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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark one)
     
þ   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2006
OR
     
o   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
Commission file number: 000-51002
ZIPREALTY, INC.
(Exact name of registrant as specified in its charter)
     
DELAWARE
(State of incorporation)
  94-3319956
(IRS employer identification number)
     
2000 POWELL STEET, SUITE 300
EMERYVILLE, CA
(Address of principal executive offices)
 
94608
(Zip Code)
(510) 735-2600
(Registrant’s telephone number)
     Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o
     Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.
Large Accelerated Filer o                     Accelerated Filer þ                     Non-Accelerated Filer o
     Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ
     We had 21,021,021 shares of common stock outstanding at November 1, 2006.
 
 

 


 

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 EXHIBIT 31.1
 EXHIBIT 31.2
 EXHIBIT 32.1
 EXHIBIT 32.2

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Statement regarding forward-looking statements
     This report includes forward-looking statements. All statements other than statements of historical facts contained in this report, including statements regarding our future financial position, business strategy and plans and objectives of management for future operations, are forward-looking statements. The words “believe,” “may,” “will,” “should,” “could,” “estimate,” “continue,” “anticipate,” “intend,” “expect,” “plan,” “potential,” “predict” and similar expressions, as they relate to us, are intended to identify forward-looking statements. Forward-looking statements contained in this report include, but are not limited to, statements relating to:
    our future financial results;
 
    our future growth and expansion into new markets;
 
    our future advertising and marketing activities; and
 
    our future investment in technology.
     We have based these forward-looking statements largely on our current expectations and projections about future events and financial trends that we believe may affect our financial condition, results of operations, business strategy and financial needs. These forward-looking statements are subject to a number of risks, uncertainties and assumptions, including those described in “Risk Factors” in Item 1A of Part II. No forward-looking statement is a guarantee of future performance and you should not place undue reliance on any forward-looking statement.
     In light of these risks, uncertainties and assumptions, the forward-looking events and circumstances discussed in this report may not occur and actual results could differ materially from those anticipated or implied in the forward-looking statements. Except as otherwise required by law, we do not intend to update or revise any forward-looking statement contained in this report.
Trademarks
     “ZipRealty,” “ZipAgent,” “ZipNotify,” “Real-Estate.com” and “Your home is where our heart is” are our registered trademarks in the United States. “REALTOR” and “REALTORS” are registered trademarks of the National Association of REALTORS®. All other trademarks, trade names and service marks appearing in this report are the property of their respective owners.
Internet Site
     Our Internet address is www.ziprealty.com. We make publicly available free of charge on our Internet website our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission. Information contained on our website is not a part of this quarterly report on Form 10-Q.
Where You Can Find Additional Information
     You may review a copy of this quarterly report on Form 10-Q, including exhibits and any schedule filed therewith, and obtain copies of such materials at prescribed rates, at the Securities and Exchange Commission’s Public Reference Room in Room 1580, 100 F Street, NE, Washington, D.C. 20549-0102. You may obtain information on the operation of the Public Reference Room by calling the Securities and Exchange Commission at 1-800-SEC-0330. The Securities and Exchange Commission maintains a website (http://www.sec.gov) that contains reports, proxy and information statements and other information regarding registrants, such as ZipRealty, that file electronically with the Securities and Exchange Commission.

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PART I — FINANCIAL INFORMATION
Item 1. Unaudited Condensed Consolidated Financial Statements:
ZIPREALTY, INC.
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except per share amounts)
                 
    September 30,     December 31,  
    2006     2005  
Assets
               
Current assets
               
Cash and cash equivalents
  $ 9,441     $ 6,868  
Short-term investments
    78,928       82,041  
Accounts receivable, net of allowance of $38 and $42 at September 30, 2006 and December 31, 2005, respectively
    1,946       1,634  
Prepaid expenses and other current assets
    2,717       3,138  
Current and deferred income taxes
    679       500  
 
           
Total current assets
    93,711       94,181  
Restricted cash
    90       90  
Property and equipment, net
    3,817       2,538  
Investment in non-consolidated companies
    28        
Deferred tax assets, net
    17,053       17,053  
Other assets
    421       91  
 
           
Total assets
  $ 115,120     $ 113,953  
 
           
Liabilities and Stockholders’ Equity
               
Current liabilities
               
Accounts payable
  $ 1,525     $ 1,631  
Accrued expenses
    6,889       8,503  
 
           
Total current liabilities
    8,414       10,134  
Other long-term liabilities
    569       38  
 
           
Total liabilities
    8,983       10,172  
 
           
Commitments and contingencies (Note 8)
               
Stockholders’ equity
               
Common stock: $0.001 par value; 100,000 shares authorized; 20,488 and 20,273 shares issued and outstanding at September 30, 2006 and December 31, 2005, respectively
    20       20  
Additional paid-in capital
    132,331       130,077  
Common stock warrants
    6,094       6,094  
Deferred stock-based compensation
    (92 )     (257 )
Accumulated other comprehensive loss
    (167 )     (490 )
Accumulated deficit
    (32,049 )     (31,663 )
 
           
Total stockholders’ equity
    106,137       103,781  
 
           
Total liabilities and stockholders’ equity
  $ 115,120     $ 113,953  
 
           
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

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ZIPREALTY, INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
                                 
    Three months ended September 30,     Nine months ended September 30,  
    2006     2005     2006     2005  
Net transaction revenues
  $ 25,420     $ 27,576     $ 70,263     $ 70,122  
Referral and other revenues
    765       667       2,048       1,696  
 
                       
Net revenues
    26,185       28,243       72,311       71,818  
 
                       
 
                               
Operating expenses
                               
Cost of revenues
    14,238       15,565       39,568       39,467  
Product development
    1,284       760       3,838       1,965  
Marketing and customer acquisition
    3,116       3,637       9,413       9,729  
General and administrative
    7,922       6,062       22,831       15,807  
Litigation
                      4,164  
 
                       
Total operating expenses
    26,560       26,024       75,650       71,132  
 
                       
 
                               
Income (loss) from operations
    (375 )     2,219       (3,339 )     686  
 
                       
Other income (expense), net
                               
Interest income
    1,086       715       2,782       1,967  
Other expense, net
    (8 )     (8 )     (8 )     (11 )
 
                       
Total other income, net
    1,078       707       2,774       1,956  
 
                       
 
                               
Income (loss) before income taxes
    703       2,926       (565 )     2,642  
Provision for (benefit from) income taxes
    81       76       (179 )     76  
 
                       
Net income (loss)
  $ 622     $ 2,850     $ (386 )   $ 2,566  
 
                       
 
                               
Net income (loss) per share:
                               
Basic
  $ 0.03     $ 0.14     $ (0.02 )   $ 0.13  
Diluted
  $ 0.03     $ 0.11     $ (0.02 )   $ 0.10  
Weighted average common shares outstanding:
                               
Basic
    20,410       20,198       20,356       20,031  
Diluted
    23,478       25,328       20,356       25,487  
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

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ZIPREALTY, INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
                 
    Nine months ended September 30,  
    2006     2005  
Cash flows from operating activities
               
Net income (loss)
  $ (386 )   $ 2,566  
Adjustments to reconcile net income (loss) to net cash provided by operating activities
               
Deferred income tax benefit
    (179 )      
Depreciation and amortization
    1,744       1,065  
Stock-based compensation expense
    1,884       106  
Provision for doubtful accounts
    (4 )     13  
Amortization of short-term investment premium (discount)
    (2 )     515  
Loss on disposal of property and equipment
    15        
Changes in operating assets and liabilities
               
Accounts receivable
    (308 )     (975 )
Prepaid expenses and other current assets
    421       (479 )
Other assets
    (180 )     (69 )
Accounts payable
    (106 )     (125 )
Accrued expenses
    (1,614 )     5,506  
Other long-term liabilities
    531       (41 )
 
           
Net cash provided by operating activities
    1,816       8,082  
 
           
Cash flows from investing activities
               
Purchases of short-term investments
    (51,102 )     (26,650 )
Proceeds from sale and maturity of short-term investments
    54,540       16,167  
Purchases of property and equipment
    (3,038 )     (1,954 )
Purchase of intangible asset
    (150 )      
Investment in non-consolidated companies
    (28 )      
 
           
Net cash provided by (used in) investing activities
    222       (12,437 )
 
           
Cash flows from financing activities
               
Proceeds from stock option exercises
    535       448  
Proceeds from common stock warrant exercises
          11  
 
           
Net cash provided by financing activities
    535       459  
 
           
Net increase (decrease) in cash and cash equivalents
    2,573       (3,896 )
 
           
Cash and cash equivalents at beginning of period
    6,868       11,525  
 
           
Cash and cash equivalents at end of period
  $ 9,441     $ 7,629  
 
           
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. BACKGROUND AND BASIS OF PRESENTATION
     The accompanying unaudited interim condensed consolidated financial statements as of September 30, 2006 and 2005 and for the three and nine months then ended have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and the rules and regulations of the U.S. Securities and Exchange Commission. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for annual financial statements. In the opinion of the Company’s management, the unaudited interim condensed consolidated financial statements have been prepared on the same basis as the audited financial statements, except for the adoption of SFAS 123(R), as explained in Note 4, and include all adjustments, consisting only of normal recurring adjustments, necessary for the fair presentation of the Company’s financial position for the periods presented. The results for the three and nine months ended September 30, 2006 are not necessarily indicative of the results to be expected for the year ending December 31, 2006, or any other period. The balance sheet at December 31, 2005 has been derived from the audited balance sheet at that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. These financial statements and notes should be read in conjunction with the audited financial statements and notes thereto included in the Company’s annual report on Form 10-K for the year ended December 31, 2005.
     On June 1, 2006 the Company formed a wholly owned subsidiary, ZipRealty Title Holdings, LLC and on June 5, 2006 the Company formed a wholly owned subsidiary, Highline Insurance Services, LLC. These subsidiaries were formed for the purpose of offering services relating to the purchase, sale and ownership of a home, including services related to title insurance and property and casualty insurance. On June 16, 2006 ZipRealty Title Holdings, LLC entered into a joint venture with an independent third party title company. No operations had commenced as of September 30, 2006 for any of the entities.
     The unaudited interim condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries and reflect the elimination of intercompany accounts and transactions. Investments in business entities in which the Company does not have control, but has the ability to exercise significant influence over operating and financial policies are accounted for using the equity method.
     The Company accounts for interests in variable interest entities (“VIEs”) in accordance with Financial Accounting Standards Board Interpretation No. 46 (“FIN 46”), as amended. The Company consolidates all VIEs for which the Company is deemed to be the primary beneficiary.
Reclassifications
     Certain prior year amounts have been reclassified to conform to the current period’s presentation.
Stock split
     In August 2004, the Company’s stockholders approved a reverse stock split of the Company’s common and redeemable convertible preferred stock in a range of one for two to one for three shares. The actual split ratio of one for three shares of the Company’s common and redeemable convertible preferred stock was approved by the Company’s Board of Directors (“BOD”) on October 21, 2004, following stockholder approval of the range. On November 8, 2004, the reverse stock split became effective. All share, per share and stock option data information in the financial statements for all periods have been retroactively restated to reflect the reverse stock split.
Initial public offering
     On November 9, 2004, the Securities and Exchange Commission declared effective the Company’s Registration Statement on Form S-1 (File No. 333-115657) for the initial public offering. The Company commenced the offering immediately thereafter. The Company completed the sale of 4,550,000 shares of common stock on November 15, 2004 at a price of $13.00 per share, and on November 18, 2004 the Company sold the remainder of the registered shares of common stock (682,500 shares) at the same price per share pursuant to the underwriters’ exercise of the over-allotment option. UBS Securities LLC, Deutsche Bank Securities Inc., Thomas Weisel Partners LLC and Pacific Growth Equities, LLC acted as the underwriters for the offering.

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     The aggregate purchase price of the offering was $68,022,500. The net offering proceeds received by the Company after deducting total estimated expenses were $61,402,757. The Company incurred total estimated expenses in connection with the offering of $6,619,743, which consisted of $1,795,943 in legal, accounting and printing fees, $4,761,575 in underwriters’ discounts, fees and commissions, and $62,225 in miscellaneous expenses. No payments for such expenses were made directly or indirectly to (i) any of the Company’s directors, officers or their associates, (ii) any person owning 10% or more of any class of the Company’s equity securities or (iii) any of the Company’s affiliates.
     Upon the closing of the Company’s initial public offering on November 15, 2004, 13,025,620 shares of outstanding redeemable convertible preferred stock converted into common stock. Therefore, at September 30, 2006 and December 31, 2005, there were no outstanding shares of redeemable convertible preferred stock.
     All outstanding warrants to acquire preferred stock automatically became exercisable for common stock upon the first closing of the Company’s initial public offering.
Seasonality
     The Company’s net transaction revenues and income (loss) from operations have historically varied from quarter to quarter. Such variations are principally attributable to variations in home sales activity over the course of the calendar year. The Company has historically experienced lower net transaction revenues during the first quarter because holidays and adverse weather conditions in certain regions typically reduce the level of sales activity and listings inventories between the Thanksgiving and Presidents’ Day holidays. Net transaction revenues during the three months ended September 30, 2005 and 2004 accounted for approximately 30.3% and 28.2% of annual net transaction revenues in 2005 and 2004, respectively. Net transaction revenues during the nine months ended September 30, 2005 and 2004 accounted for approximately 77.0% and 71.9% of annual net transaction revenues in 2005 and 2004, respectively.
2. RECENT ACCOUNTING PRONOUNCEMENTS
     In June 2006, the FASB issued Financial Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”). FIN 48 prescribes detailed guidance for the financial statement recognition, measurement and disclosure of uncertain tax positions recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes” (“SFAS 109”). Tax positions must meet a more-likely-than-not recognition threshold at the effective date to be recognized upon the adoption of FIN 48 and in subsequent periods. FIN 48 will be effective for fiscal years beginning after December 15, 2006, and the provisions of FIN 48 will be applied to all tax positions accounted for under SFAS 109 upon initial adoption. The cumulative effect of applying the provisions of this interpretation will be reported as an adjustment to the opening balance of retained earnings for that fiscal year. We are currently evaluating the impact, if any, of FIN 48 on our financial statements.
3. SHORT-TERM INVESTMENTS
     At September 30, 2006 short-term investments were classified as available-for-sale securities, except for restricted cash, and are reported at fair value as follows:
                                 
            Gross     Gross        
    Gross Amortized     Unrealized     Unrealized     Estimated  
    Cost     Gains     Losses     Fair Value  
    (in thousands)  
Money market securities
  $ 6,076     $     $     $ 6,076  
Repurchase agreements
    700                   700  
Asset backed
    24,209       22       (33 )     24,198  
Corporate obligations
    33,786       40       (97 )     33,729  
US Government and agency obligations
    21,100       12       (111 )     21,001  
 
                       
Total short-term investments
  $ 85,871     $ 74     $ (241 )   $ 85,704  
 
                       
         
    September 30,  
    2006  
    (in thousands)  
Recorded as:
       
Cash equivalents
  $ 6,776  
Short-term investments
    78,928  
 
     
 
  $ 85,704  
 
     
     At September 30, 2006, the fair value of the Company’s investments which had been in an unrealized loss position for over twelve months was $22.5 million and the related unrealized loss was approximately $167,000.
     The estimated fair value of short-term investments classified by date of contractual maturity at September 30, 2006 are as follows:
         
    September 30,  
    2006  
    (in thousands)  
Due within one year or less
  $ 33,210  
Due after one year through two years
    31,668  
Due after two years through four years
    20,826  
 
     
 
  $ 85,704  
 
     

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4. NET INCOME (LOSS) PER SHARE
     The following table sets forth the computation of basic and dilutive net income (loss) per share for the periods indicated:
                                 
    Three Months Ended September 30,     Nine Months Ended September 30,  
    2006     2005     2006     2005  
    (in thousands, except per share data)  
Numerator:
                               
Net income (loss)
  $ 622     $ 2,850     $ (386 )   $ 2,566  
 
                       
Denominator:
                               
Weighted average common shares outstanding:
                               
Basic
    20,410       20,198       20,356       20,031  
Diluted
    23,478       25,328       20,356       25,487  
Net income (loss) per share:
                               
Basic
  $ 0.03     $ 0.14     $ (0.02 )   $ 0.13  
Diluted
  $ 0.03     $ 0.11     $ (0.02 )   $ 0.10  
 
     The following table sets forth potential common shares that are not included in the diluted net income (loss) per share calculation because to do so would be anti-dilutive for the periods presented:
                                 
    Three Months Ended September 30,   Nine Months Ended September 30,
    2006   2005   2006   2005
            (in thousands)        
Stock options to purchase common stock
    3,052       866       4,363       633  
Warrants to purchase common stock
    3       3       4,603       3  
5. STOCK-BASED COMPENSATION
     Effective January 1, 2006, the Company adopted the provisions of SFAS 123 (Revised 2004), Share-Based Payment (“SFAS 123(R)”) which requires the measurement and recognition of compensation expense for all stock-based payment awards made to employees and directors, including employee stock options and employee stock purchases, based on estimated fair values. On March 29, 2005, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin No. 107 (“SAB 107”) which provides the SEC Staff’s views regarding interactions between SFAS 123(R) and certain SEC rules and regulations and provides interpretations of the valuation of share-based payments for public companies. The Company adopted SFAS 123(R) using the modified prospective transition method, which requires application of the accounting standard as of January 1, 2006, the first day of fiscal year 2006. The Unaudited Condensed Consolidated Financial Statements as of and for the three and nine months ended September 30, 2006 reflect the impact of SFAS 123(R). In accordance with the modified prospective transition method, the consolidated financial statements for prior periods have not been restated to reflect the impact of SFAS 123(R). Therefore, the results for the three and nine months ended September 30, 2006 are not directly comparable to the same periods in the prior year.
     The Company accounts for equity instruments issued to non-employees in accordance with the provisions of SFAS No. 123(R) and Emerging Task Force Issue No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services (“EITF 96-18”).
Prior to the adoption of SFAS 123(R)
     Prior to the adoption of SFAS 123(R), the Company accounted for employee stock-based compensation arrangements in accordance with provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”) and Financial Accounting Standards Board Interpretation No. 44, Accounting for Certain Transactions Involving Stock Compensation — an Interpretation of APB No. 25 (“FIN 44”) and complied with the disclosure provisions of Statement of Financial Accounting Standard No. 123, Accounting for Stock-Based Compensation (“SFAS 123”) as amended by Statement of Financial Accounting Standard No. 148, Accounting for Stock-Based Compensation — Transaction and Disclosure (“SFAS 148”). Under APB 25, compensation expense was based on the difference, if any, on the date of the grant, between the fair value of the Company’s stock and the exercise price of the option. The Company amortized deferred stock-based compensation using the straight-line method.

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     The following table illustrates the effect on net income if the Company had applied the fair-value recognition provisions of SFAS No. 123, as amended by SFAS 148, to stock-based employee compensation.
                 
    Three Months Ended     Nine Months Ended  
    September 30     September 30  
    2005     2005  
Net income as reported
  $ 2,850     $ 2,566  
Deduct: Total stock-based employee compensation expense determined under the fair value based method for all awards, net of tax
    (326 )     (827 )
 
           
Pro forma net income
  $ 2,524     $ 1,739  
 
           
Net income per share, as reported:
               
Basic
  $ 0.14     $ 0.13  
Diluted
  $ 0.11     $ 0.10  
Pro forma net income per share:
               
Basic
  $ 0.12     $ 0.09  
Diluted
  $ 0.10     $ 0.07  
     The stock-based employee compensation determined under the fair-value method for the three and nine months ended September 30, 2005 have been adjusted to exclude the effect of the options granted prior to the Company’s filing of the registration statement for an initial public offering in May 2004, as those options were valued for pro forma disclosure purposes using the minimum value method.
Impact of the Adoption of SFAS 123(R)
     The Company elected to adopt the modified prospective transition method as provided by SFAS 123(R) except for options granted prior to the Company’s filing of the registration statement for an initial public offering in May 2004, that vested during the period for which the fair value was determined for disclosure purposes using the minimum value method. Under this transition method, stock-based compensation cost recognized in the three and nine months ended September 30, 2006 includes:
    compensation cost for all unvested stock-based awards as of January 1, 2006 that were granted subsequent to the Company’s filing of the registration statement for an initial public offering in May 2004, and prior to January 1, 2006, that vested during the period based on the grant date fair value estimated in accordance with the original provisions of SFAS 123;
 
    compensation cost for stock-based awards granted subsequent to January 1, 2006, that vested during the period based on the grant date fair value estimated in accordance with the provisions of SFAS 123(R); and
 
    compensation cost for options granted prior to the Company’s filing of the registration statement for an initial public offering in May 2004, that vested during the period based on the intrinsic value method.
     Previously reported amounts have not been restated. The effect of recording stock-based compensation for the three and nine months ended September 30, 2006 were as follows:
                 
    Three Months Ended     Nine Months Ended  
    September 30, 2006     September 30, 2006  
    (in thousands)     (in thousands)  
Cost of revenues
  $ 110     $ 357  
Product development
    48       135  
Marketing and customer acquisition
    (1 )     51  
General and administrative
    558       1,341  
 
           
Total stock-based compensation
    715       1,884  
Tax effect on stock-based compensation
    (286 )     (754 )
 
           
Net effect on net income
  $ 429     $ 1,130  
 
           
Effect on earnings per share:
               
Basic
  $ 0.02     $ 0.06  
 
           
Diluted
  $ 0.02     $ 0.06  
 
           
     There was no impact on cash flows from operating activities or financing activities during the three and nine months ended September 30, 2006 as a result of the adoption of SFAS 123(R). In the Company’s pro forma disclosures prior to the adoption of SFAS 123(R) the Company accounted for forfeitures upon occurrence. SFAS 123(R) requires forfeitures to be estimated at the time of

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grant and revised if necessary in subsequent periods if actual forfeitures differ from those estimates. The Company estimated expected forfeitures based on various factors including employee class and historical experience. As of September 30, 2006, there was $9.9 million of unrecorded total stock-based compensation, after estimated forfeitures, related to unvested stock options. That cost is expected to be recognized over a weighted average remaining recognition period of 3.2 years.
Valuation Assumptions
     SFAS 123(R) requires companies to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service period in the Company’s financial statements. In connection with the adoption of SFAS 123(R), the Company reassessed its valuation technique and related assumptions.
     The Company estimates the fair value of stock options using the Black-Scholes option pricing model, which incorporates various assumptions including volatility, expected life and interest rates. The expected volatility is based on the historical volatility of the Company’s common stock and consideration of other relevant factors such as the volatility assumptions of peer companies. The expected life of options granted during the three and nine months ended September 30, 2006 is estimated by taking the average of the vesting term and the contractual term of the option as provided by SAB 107.
     The assumptions used for the three and nine months ended September 30, 2006 and 2005 and the resulting estimates of weighted average fair value per share of options granted during those periods are as follows:
                                 
    Three Months Ended September 30,   Nine Months Ended September 30,
    2006   2005   2006   2005
Expected volatility
    51%       40%       51-52%       33-40%  
Risk-free interest rate
    4.8-4.9%       4.0%       4.3-5.0%       3.8-4.1%  
Expected life (years)
    6.0-6.1       4       5.5-6.1       4  
Expected dividend yield
    0%       0%       0%       0%  
Weighted-average fair value of options granted during the period
    $3.30       $5.11       $3.90       $4.88  
Stock Option Activity
     A summary of the Company’s stock option activity for the periods indicated follows:
                                 
                    Weighted    
            Weighted   Average    
            Average   Remaining    
    Number of   Exercise   Contractual   Aggregate
    Shares   Price   Life (Years)   Intrinsic Value
    (in thousands)                   (in thousands)
Outstanding at January 1, 2006
    3,652     $ 7.01                  
Options granted
    653     $ 8.41                  
Options exercised
    (45 )   $ 3.18                  
Options forfeited or expired
    (82 )   $ 11.88                  
 
                               
Outstanding at March 31, 2006
    4,178     $ 7.17       7.68       13,778  
 
                               
Options granted
    474     $ 8.80                  
Options exercised
    (77 )   $ 3.08                  
Options forfeited or expired
    (113 )   $ 11.22                  
 
                               
Outstanding at June 30, 2006
    4,462     $ 7.31       7.66       12,442  
 
                               
Options granted
    1,462     $ 6.05                  
Options exercised
    (93 )   $ 1.66                  
Options forfeited or expired
    (296 )   $ 11.71                  
 
                               
Outstanding at September 30, 2006
    5,535     $ 6.84       8.05       11,475  
 
                               
Options exercisable at September 30, 2006
    2,503     $ 5.18       6.38       9,432  
 
                               
     Aggregate intrinsic value represents the difference between the Company’s closing stock price on the last trading day of the fiscal period, which was $7.36 on September 30, 2006, and the exercise price for the options that were in-the-money at September 30, 2006. The total number of in-the-money options exercisable as of September 30, 2006 was 1,529,000. Total intrinsic value of options

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exercised was $1,215,000 and $2,292,000 for the nine-month periods ended September 30, 2006 and September 30, 2005, respectively.
     The Company settles employee stock option exercises with newly issued common shares.
Stock Option Plans
     In February 1999, the BOD approved and the Company adopted the 1999 Stock Option Plan (the “1999 Plan”). The 1999 Plan provides for the granting of stock options to employees and consultants of the Company. Options granted under the 1999 Plan may be either incentive stock options or nonstatutory stock options. Incentive stock options (“ISO”) may be granted only to Company employees (including officers and directors who are also employees). Nonstatutory stock options (“NSO”) may be granted to Company employees and consultants. The Company has authorized and reserved 3,362,000 shares of common stock for issuance under the 1999 Plan.
     In August 2004, the BOD approved and the Company adopted the 2004 Equity Incentive Plan (the “2004 Plan”). The 2004 Plan provides for the granting of stock options to employees and consultants of the Company. Options granted under the 2004 Plan may be either incentive stock options or nonstatutory stock options. Incentive stock options (“ISO”) may be granted only to Company employees (including officers and directors who are also employees). Nonstatutory stock options (“NSO”) may be granted to Company employees and consultants. The Company has authorized and reserved 1,000,000 shares of common stock for issuance under the 2004 Plan.
     Following the Company’s initial public offering, any shares that were reserved but not issued under the 1999 Plan were made available under the 2004 Plan, and any shares that would have otherwise returned to the 1999 Plan will be made available for issuance under the 2004 Plan. The 1999 Plan will continue to govern awards granted there under prior to the Company’s initial public offering.
     The number of shares reserved for issuance under the 2004 Plan will be increased by the number of shares which have been reserved but not issued under the 1999 Plan, any shares returned to the 1999 Plan, and an annual increase to be added on the first day of our fiscal year beginning in 2006 equal to the least of (a) 1,666,666 shares, (b) 4% of the outstanding shares on such date, or (c) an amount determined by the BOD. Pursuant to this requirement, on January 1, 2006, an additional 810,932 shares were added to the plan, reserved for issuance and registered for sale under Form S-8.
     Options under the 1999 and 2004 Plans may be granted at prices no less than 85% of the estimated fair value of the shares on the date of grant as determined by the BOD, provided, however, that (i) the exercise price of an ISO and NSO shall not be less than 100% and 85% of the estimated fair value of the shares on the date of grant, respectively, and (ii) the exercise price of an ISO and NSO granted to a 10% stockholder shall not be less than 110% of the estimated fair value of the shares on the date of grant, respectively. Options generally vest over a four-year period with one-fourth (1/4) of the shares vesting one year after the vesting commencement date, and an additional one-forty eighth (1/48) of the shares vesting on the first day of each calendar month thereafter until all such shares are exercisable. Options expire after ten years.
Other Stock Option
     In September 2006, the BOD approved the registration of 1,250,000 shares of common stock underlying an option issued outside the company’s stock option plans. The nonstatutory stock option (“NSO”) was granted in connection with the employment of the Company’s new Chief Executive Officer and vests over a four-year period with one-fourth (1/4) of the shares vesting one year after the vesting commencement date and an additional one-forty eighth (1/48) of the shares vesting on the first day of each calendar month thereafter until all such shares are exercisable. The option expires after ten years.
6. INCOME TAXES
     At the end of each interim period the Company calculates an effective tax rate based on the Company’s best estimate of the tax provision (benefit) that will be provided for the full year, stated as a percentage of estimated annual pre-tax income (loss). The tax provision (benefit) for the interim period is determined using this estimated annual effective tax rate.
     The Company has recorded a provision (benefit) for income taxes of $81,000 and $(179,000) for the three and nine months ended September 30, 2006, respectively, reflecting an annual effective tax rate of approximately 32% for 2006. The effective tax rate differs

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from the statutory rate primarily due to certain non-deductible stock-based compensation recorded upon adoption of FAS 123(R). The Company recorded a provision for income taxes of $76,000 for the three and nine months ended September 30, 2005.
7. COMPREHENSIVE INCOME (LOSS)
     Comprehensive income (loss) includes net income (loss) and unrealized gains (losses) on investments. Comprehensive income (loss) is comprised of the following:
                                 
    Three Months Ended September 30,     Nine Months Ended September 30,      
    2006     2005     2006     2005  
    (in thousands)  
Net income (loss)
  $ 622     $ 2,850     $ (386 )   $ 2,566  
Other comprehensive income (loss):
                               
Change in accumulated unrealized gain (loss) on available-for-sale securities, net of tax
    346       (156 )     322       (392 )
 
                       
Comprehensive income (loss)
  $ 968     $ 2,694     $ (64 )   $ 2,174  
 
                       
8. COMMITMENTS AND CONTINGENCIES
     The Company leases office space under non-cancelable operating leases with various expiration dates through January 2012.
     Future minimum lease payments under non-cancelable operating leases at September 30, 2006 are as follows, in thousands:
         
    Operating  
Year ending December 31,   Leases  
2006
  $ 390  
2007
    1,550  
2008
    1,264  
2009
    816  
2010
    739  
Thereafter
    781  
 
     
Total minimum lease payments
$ 5,540  
 
     
Legal Proceedings
     The Company is not currently subject to any material legal proceedings. From time to time the Company has been, and it currently is, a party to litigation and subject to claims incident to the ordinary course of the business. The amounts in dispute in these matters are not material to the Company, and management believes that the resolution of these proceedings will not have a material adverse effect on the business, financial position, results of operations or cash flows.
Indemnifications
     The Company has entered into various indemnification agreements in the ordinary course of our business. Pursuant to these agreements, the Company has agreed to indemnify, hold harmless and reimburse the indemnified parties, which include certain of the Company’s service providers as well as others, in connection with certain occurrences. In addition, the Company’s charter documents require the Company to provide indemnification rights to our directors and officers to the fullest extent permitted by the Delaware General Corporation Law, and permit the Company to provide indemnification rights to the Company’s other employees and agents, for certain events that occur while these persons are serving in these capacities. The Company has also entered into indemnification agreements with each of the Company’s directors and its officers with a title of Vice President or higher. Further, the underwriting agreement for the Company’s initial public offering requires the Company to indemnify the Company’s underwriters and certain of their affiliates and agents for certain liabilities arising from the Company’s offering and the related registration statement.
     The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unspecified. The Company is not aware of any material indemnification liabilities for actions, events or occurrences that have occurred to date. The Company maintains insurance on some of the liabilities the Company has agreed to indemnify, including liabilities incurred by the Company’s directors and officers while acting in these capacities, subject to certain exclusions and limitations of coverage.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations:
     The following discussion should be read together with our financial statements and related notes appearing elsewhere in this report. This discussion contains forward-looking statements based upon current expectations that involve numerous risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements for many reasons, including but not limited to those set forth in “Risk Factors” in Item 1A of Part II of this report and elsewhere in this report. Except as otherwise required by law, we do not intend to update any information contained in these forward-looking statements.
OVERVIEW
General
     We are a full-service residential real estate brokerage firm, using the Internet, proprietary technology and efficient business processes to provide home buyers and sellers with high-quality service and value. Our solution includes a client-centric business approach, a sophisticated website that empowers home buyers and sellers with relevant information, a proprietary business management technology platform and significant financial savings for consumers. We share a portion of our commissions with our buyer clients in the form of a cash rebate, and typically represent our seller clients at fee levels below those offered by most traditional brokerage companies in our markets. Generally, our seller clients pay a total brokerage fee of 4.5% to 5.0% of the transaction value, of which 2.5% to 3.0% is paid to agents representing buyers.
     Our net revenues are comprised primarily of commissions earned as agents for buyers and sellers in residential real estate transactions. We record revenues net of rebate or commission discount, if any, paid or offered to our clients. Our net revenues are principally driven by the number of transactions we close and the average net revenue per transaction. Average net revenue per transaction is a function of the home sales price and percentage commission we receive on each transaction. We also receive revenues from certain co-marketing arrangements, such as our relationship with E-LOAN, Inc., which provides the mortgage center on our website and pays us a flat monthly fee that is established on a periodic basis. Generally, non-commission revenues represent less than 5% of our net revenues during any period. We are currently exploring our options for offering other services related to the purchase, sale and ownership of a home.
     We were founded in 1999, currently have operations in 20 major metropolitan areas, and as of September 30, 2006 employed 1,963 people, of whom 1,747 were ZipAgents. We commenced operations in Las Vegas in April 2005, in Houston in June 2005, in Miami in October 2005, in Tampa in February 2006, in Orlando in April 2006, in Minneapolis/St. Paul in May 2006, in Austin in July 2006, and in Palm Beach in September 2006. We have announced plans to enter the Greater Philadelphia area later in the year and Naples and Tucson in the first quarter of 2007.
Trends in our business
     Our business has experienced significant growth since our inception in 1999, primarily as a result of increased transaction volume and increased average net revenue per transaction. In the three months ended September 30, 2006, we generated $26.2 million in net revenues, compared to $28.2 million in the three months ended September 30, 2005. In the nine months ended September 30, 2006 we generated $72.3 million in net revenues, compared to $71.8 million in the nine months ended September 30, 2005. The number of our closed transactions decreased to approximately 3,467 in the three months ended September 30, 2006 from approximately 3,689 in the three months ended September 30, 2005, and our average net revenue per transaction decreased to approximately $7,332 in the three months ended September 30, 2006 from approximately $7,475 in the three months ended September 30, 2005. The number of our closed transactions increased to approximately 9,657 in the nine months ended September 30, 2006 from approximately 9,407 in the nine months ended September 30, 2005, and our average net revenue per transaction decreased to approximately $7,276 in the nine months ended September 30, 2006 from approximately $7,454 in the nine months ended September 30, 2005. Our transaction volume is primarily driven by the number of ZipAgents we employ, which increased to 1,747 at September 30, 2006 from 1,383 at September 30, 2005. Our average net revenue per transaction decreased over this time primarily as a result of our growing percentage of transactions occurring in less expensive housing price markets outside of California. As we add additional ZipAgents, we believe long term we will continue to increase our transaction volume and grow our business, although this may not be the case if the market continues to soften. In addition, we believe that customer acquisition is one of our core competencies, and while we anticipate that the difficulty of acquiring a sufficient number of leads online may increase over time, we expect that we can mitigate some of that impact with repeat and referral business, as well as by increasing our visibility and credibility to potential clients over time. Since our market share has averaged less than 1% over the past twelve months in our existing markets in aggregate, we believe that there is an opportunity to increase our market share, even if the overall level of sales decline due to changing consumer sentiment, interest rate increases or other economic or geopolitical factors.

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     Since early September of 2005 we have experienced a significant increase in the available inventory of homes for sale in many of our markets, as well as an increase in the amount of time listings are taking to sell. For example, average inventories in our existing markets increased approximately 89%, and months of inventory increased approximately 154%, in the quarter ended September 30, 2006 from the quarter ended September 30, 2005. Pricing increases have also slowed, and some markets have shown declines in median selling prices over this period. According to NAR, nationally sales of existing homes fell 14.2% year-over-year in September 2006 to a seasonally adjusted annual rate of 6.18 million. In the State of California, the California Association of REALTORS reported that sales of existing homes declined 31.7% year-over-year during the month of September 2006. In our opinion, these data points suggest the housing market is in a period of transition, with more power shifting to buyers from sellers, and that the residential real estate market may continue to soften in the foreseeable future. While over the long-term we believe a more balanced market will be beneficial to our model, which relies primarily on representing buyers, during this period of transition we may continue to experience reduced growth rates and agent productivity versus our historical levels as buyers react cautiously to perceived changing market conditions.
     Over time, we have made significant adjustments to our cost structure and revenue model in order to improve the financial results of our business. We have modified the compensation and expense reimbursement structure for ZipAgents over time, and we most recently changed our commission and/or expense structure in February 2006. Currently, our ZipAgents earn a compensation package consisting of a percentage of the commissions they generate for us that ranges from 35% to 80% of our net revenues after deducting certain other items. We also provide our ZipAgents with health, retirement and other benefits, and pay for certain marketing costs and other business expenses. ZipAgents may also be granted equity incentives based on performance. We may make further modifications to our compensation structure in the future.
     We have lowered our buyer rebate percentage several times to improve our revenue model. In March 2004, we reduced our buyer rebate to 20% of our commission from 25% of our commission, up to a maximum of 1% of the home sales price. The effect of the buyer rebate reduction was recognized over a phase-in period of approximately two to four months as the reduction only affected new clients immediately while existing clients continued under the prior rebate policy for transactions already in progress and for transactions opened within a short period after the reduction was announced. We implemented these buyer rebate percentage reductions for several reasons, including our determination that our growing reputation for superior service allowed us not to compete solely on price, our efforts to improve our revenue model and agent compensation model, and our desire to offer a simplified rebate structure to our clients.
     We achieved profitability for the first time in the third quarter of 2003 and maintained profitability for the fourth quarter as well, primarily as a result of increased transaction volume, higher average net revenue per transaction and improved management of discretionary expenses. However, as a result of the seasonality to which our business is subject, we again experienced a net loss in the first quarter of 2004. We returned to profitability in the second, third and fourth quarters of 2004, primarily as a result of higher average net transaction revenue and increased transactional volume due to our increased ZipAgent force and seasonal factors. We achieved profitability in the first quarter of 2005, the first time in our seasonally slow first quarter, primarily as a result of higher average net transaction revenues and increased transactional volume due to our increased ZipAgent force. While we experienced a net loss in the second quarter of 2005 as a result of a one-time charge relating to the settlement of a threatened class action lawsuit, we would have been profitable excluding the effect of this settlement. We again achieved profitability in the third and fourth quarters of 2005, but because of seasonality and new market expansion as well as the current softening in the residential real estate market, we experienced a net loss in the first and second quarters of 2006. We achieved profitability in the third quarter of 2006, but are facing the possibility of loss in the last quarter in 2006 in light of current market and geopolitical uncertainties.
     Over the past several years there has been a decline in average commissions charged in the real estate brokerage industry, in part due to companies such as ours exerting downward pressure on prices with a lower commission structure, as well as by what, in our view, appears to be an increase in consumer willingness to negotiate fees with their agents. We believe that many consumers are focusing on absolute commission dollars paid to sell their home as opposed to accepting a traditional standard market commission percentage. According to REAL Trends, while the average commission percentage decreased from 5.44% in 2000 to 5.02% in 2005, total commission revenues increased from $42.6 billion to $65.5 billion during that same period, influenced by steadily increasing sales volumes and higher median sales prices. In the event that commissions continue to decline, we have designed our business model around an attractive cost structure and operational efficiencies which we believe should allow us to continue to offer our services at prices less than those charged by the majority of our competitors.
     In addition, the competitive landscape in the residential real estate industry is in the midst of significant changes as new business models enter the marketplace. For example, Redfin Corporation has introduced a discount brokerage model (currently in two states)

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that allows clients to make offers to purchase homes and to list homes for sale directly online, while receiving a two-thirds rebate of their commission. BuySide Realty, another discount brokerage, employs agents who are paid salaries and bonuses based on customer service, not commissions, while offering a 75% rebate of their commission. Realestate.com, which is owned by LendingTree, LLC, acts as a lead generator for real estate brokers and agents, and has recently opened a direct to consumer brokerage service. Trulia, Inc. operates a residential real estate search engine to connect consumers directly to listings on agent and broker web sites. In order to continue growing, our business model must remain attractive to consumers so that we can compete successfully with these newer models as they expand into our marketplaces. In addition, to remain economically viable, we will need to be able to compete effectively with these new entrants for the acquisition of agents and leads.
Market seasonality, cyclicality and interest rate influences
     The residential real estate brokerage market is influenced both by annual seasonality factors, as well as by overall economic cycles. While individual markets vary, transaction volume activity nationally tends to progressively increase from January through the summer months, then gradually slows over the last three to four months of the calendar year. Revenues in each quarter are significantly affected by activity during the prior quarter, given the typical 30- to 45-day time lag between contract execution and closing. While we believe that, until fairly recently, seasonality has been somewhat masked by our overall growth, we have been, and believe we will continue to be, influenced by overall market activity and seasonal forces. We generally experience the most significant impact in the first and fourth quarters of each year, when our revenues are typically lower relative to the second and third quarters as a result of traditionally slower home sales activity and reduced listings inventory between Thanksgiving and Presidents’ Day.
     We believe that the overall macroeconomic environment and periodic business cycles can influence the general health of the residential real estate market at any given point in time. Generally, when economic times are fair or good, the housing market tends to perform well. If the economy is weak, interest rates dramatically increase, or there are market events such as terrorist attacks or threats, the outbreak of war or geopolitical uncertainties, the housing market could be negatively impacted.
     Over the past several decades, the national residential real estate market has demonstrated significant growth, with annual existing home sales volume growing from 1.6 million in 1970 to approximately 7.1 million in 2005 and median existing home sales prices increasing every year during that period. During that period, the volume of existing home sales has declined for at least two consecutive years only twice, namely 1979 through 1982 and 1989 through 1990. The declines in sales volumes in the 1979 through 1982 period occurred while interest rates were at historic highs, with long-term U.S. Treasury rates exceeding 10%. With rates remaining at similarly high levels, housing activity expanded during the period from 1983 through 1986. Average interest rates were lower during the second period of consecutive year declines, 1989 through 1990, than in 1988.
     Many factors influence an individual’s decision to buy or sell a home, and we believe that no one factor alone determines the health of the residential real estate market. For example, a rise in interest rates could lead to lower demand for housing or put downward pressure on prices because, all else being equal, it should increase monthly housing payments or reduce the amount an individual can pay for a home. However, it is also our experience that lifestyle influences, such as job relocation, changes in family dynamics or a desire to change neighborhoods, significantly impact the demand for residential real estate. In addition, periods of interest rate increases are often characterized by improving economic fundamentals, which can create jobs, increase incomes and bolster consumer confidence, all of which are factors that positively influence housing demand. It is difficult to predict which influences will be strongest, and ultimately whether the housing market will be affected positively or negatively when faced with numerous influences.
     While it is difficult to isolate the cause of recent transaction volume declines and pricing growth slowing in the residential real estate market, such softening has been occurring since Fall of 2005 as interest rates have been increasing. Other factors have likely contributed to the slowdown as well, such as high fuel prices, persistent press coverage about residential real estate potentially being poised for a correction, and the fact that prices had until that time been increasing at historically high rates. This rapid price appreciation, which was well ahead of household income growth, along with increasing interest rates has made housing less affordable, which has manifested itself in declining home ownership rates, which peaked in 2004. With overall transaction activity declining and sales price increases slowing, overall commissions generated in the industry could decline as well, potentially causing the roughly $65.5 billion in annual commissions generated in 2005 to decline. However, should the addressable market for our services decline somewhat due to decreasing sales volume or prices, we believe the overall size of the market on an absolute basis will remain very large, providing ample addressable opportunity for us to continue to grow our business through increasing our market share.

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CRITICAL ACCOUNTING POLICIES AND ESTIMATES
     Our financial statements are prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, costs and expenses and related disclosures. On an ongoing basis, we evaluate our estimates and assumptions. Accordingly, our actual results may differ from these estimates under different assumptions or conditions.
     We believe that the following accounting policies involve the greatest degree of judgment and complexity. Accordingly, these are the policies we believe are the most critical to understand and evaluate our financial condition and results of operations.
Recent accounting pronouncements
     In June 2006, the FASB issued Financial Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”). FIN 48 prescribes detailed guidance for the financial statement recognition, measurement and disclosure of uncertain tax positions recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes” (“SFAS 109”). Tax positions must meet a more-likely-than-not recognition threshold at the effective date to be recognized upon the adoption of FIN 48 and in subsequent periods. FIN 48 will be effective for fiscal years beginning after December 15, 2006, and the provisions of FIN 48 will be applied to all tax positions accounted for under SFAS 109 upon initial adoption. The cumulative effect of applying the provisions of this interpretation will be reported as an adjustment to the opening balance of retained earnings for that fiscal year. We are currently evaluating the impact, if any, of FIN 48 on our financial statements.
Revenue recognition
     We derive the substantial majority of our revenues from commissions earned as agents for buyers and sellers in residential real estate transactions. We recognize commission revenues upon closing of a sale and purchase transaction, net of any rebate or commission discount, or transaction fee adjustment, as evidenced by the closure of the escrow or similar account and the transfer of these funds to all appropriate parties. We recognize non-commission revenues from our other business relationships, such as our E-LOAN marketing relationship, as the fees are earned from the other party typically on a monthly fee basis. Revenues are recognized when there is persuasive evidence of an arrangement, the price is fixed or determinable, collectibility is reasonably assured and the transaction has been completed.
Internal-use software and website development costs
     We account for internal-use software and website development costs, including the development of our ZipAgent Platform, in accordance with the guidance set forth in Statement of Position 98-1, Accounting for the Cost of Computer Software Developed or Obtained for Internal Use and Emerging Task Force Issue No. 00-02, Accounting for Website Development Costs. We capitalize the payroll and direct payroll-related costs of employees who devote time to the development of internal-use software. We amortize these costs over their estimated useful lives, which is generally 15 months. Our judgment is required in determining the point at which various projects enter the stages at which costs may be capitalized, in assessing the ongoing value of the capitalized costs, and in determining the estimated useful lives over which the costs are amortized. The estimated life is based on management’s judgment as to the product life cycle.
Stock-based compensation
     Effective January 1, 2006, we adopted the provisions of SFAS 123 (Revised 2004), Share-Based Payment (“SFAS 123(R)”) which requires the measurement and recognition of compensation expense for all stock-based payment awards made to employees and directors, including employee stock options and employee stock purchases, based on estimated fair values. Prior to adopting SFAS 123(R) we accounted for employee stock-based compensation arrangements in accordance with provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB25”). Under the fair value recognition provisions for SFAS 123(R), stock-based compensation cost is estimated at the grant date based on the fair value of the awards expected to vest and recognized as expense using the straight-line method over the requisite service period of the award. We elected to adopt the modified prospective transition method as provided by SFAS 123(R) except for options granted prior to our filing of the registration statement for an initial public offering in May 2004, for which the fair value was determined for disclosure purposes using the minimum value method. Under this transition method, stock-based compensation cost recognized in the three and nine months ended September 30, 2006 includes:

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    compensation cost for all unvested stock-based awards as of January 1, 2006 that were granted subsequent to our filing of the registration statement for an initial public offering in May 2004, and prior to January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123;
 
    compensation cost for stock-based awards granted subsequent, to January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS 123(R); and
 
    compensation cost for options granted prior to our filing of the registration statement for an initial public offering in May 2004, based on the intrinsic value method.
     In accordance with the modified prospective transition method, the financial statements for prior periods have not been restated to reflect the impact of SFAS 123(R). We estimate the fair value of stock options using the Black-Scholes option pricing model, which incorporates various assumptions including volatility, expected life and interest rates. The expected volatility is based on the historical volatility of our common stock and consideration of other relevant factors such as the volatility assumptions of peer companies. The expected life of options is estimated by taking the average of the vesting term and the contractual term of the option as provided by SAB 107. We estimate expected forfeitures based on various factors including employee class and historical experience.
     We account for equity instruments issued to non-employees in accordance with the provisions of SFAS No. 123(R) and Emerging Task Force Issue No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services (“EITF 96-18”).
     The accounting for and disclosure of employee and non-employee equity instruments, primarily stock options and preferred and common stock warrants, requires judgment by management on a number of assumptions, including the fair value of the underlying instrument, estimated lives of the outstanding instruments, and the instrument’s volatility. Changes in key assumptions will impact the valuation of such instruments. Because there was no public market for our stock prior to our initial public offering in November 2004, our Board of Directors determined the fair value of our common and preferred stock based on several factors, including, but not limited to, our operating and financial performance, recent sales of convertible debt instruments and internal valuation analyses considering key terms and rights of the related instruments.
     For options granted after our initial public offering, the fair value of our common stock is the closing price of our stock on the Nasdaq National Market on the date the option was granted. For options which were granted prior to our initial public offering, the deemed fair value of our common stock was determined by our Board of Directors, with input from management, utilizing the market approach, considering a number of factors, including, but not limited to:
    comparable values of similar companies and the pricing of recent rounds of financing;
 
    revenue growth and profitability milestones achieved and as measured to budget;
 
    continued growth in experience of our management team;
 
    marketplace activity and competition;
 
    barriers to entry; and
 
    status of capital markets.
Income taxes
     Deferred tax assets and liabilities arise from the differences between the tax basis of an asset or liability and its reported amount in the financial statements as well as from net operating loss and tax credit carryforwards. Deferred tax amounts are determined by using the tax rates expected to be in effect when the taxes will actually be paid or refunds received, as provided under current tax law. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. Income tax expense or benefit is the tax payable or refundable, respectively, for the period plus or minus the change during the period in deferred tax assets and liabilities.

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     Historically, we have recorded a valuation allowance on our deferred tax assets, the majority of which relate to net operating loss tax carryforwards generated before we achieved profitability. During the fourth quarter of 2005, we concluded that it is more likely than not that we will be able to realize the benefit of a significant portion of these deferred tax assets in the future, and we released substantially all of the deferred tax valuation allowance.
RESULTS OF OPERATIONS
     The following table summarizes certain financial data related to our operations:
                                 
    Three Months Ended     Nine Months Ended  
    September 30,     September 30,  
Statements of operations data (unaudited)   2006     2005     2006     2005  
    (in thousands, except per share data)  
Net transaction revenues
  $ 25,420     $ 27,576     $ 70,263     $ 70,122  
Referral and other revenues
    765       667       2,048       1,696  
 
                       
Net revenues
    26,185       28,243       72,311       71,818  
 
                       
Operating expenses:
                               
Cost of revenues
    14,238       15,565       39,568       39,467  
Product development
    1,284       760       3,838       1,965  
Marketing and customer acquisition
    3,116       3,637       9,413       9,729  
General and administrative
    7,922       6,062       22,831       15,807  
Litigation
                      4,164  
 
                       
Total operating expenses
    26,560       26,024       75,650       71,132  
 
                       
 
                               
Income (loss) from operations
    (375 )     2,219       (3,339 )     686  
 
                       
Other income (expense):
                               
Interest income
    1,086       715       2,782       1,967  
Other expense, net
    (8 )     (8 )     (8 )     (11 )
 
                       
Total other income (expense), net
    1,078       707       2,774       1,956  
 
                       
 
                               
Income (loss) before income taxes
    703       2,926       (565 )     2,642  
Provision for (benefit from) for income taxes
    81       76       (179 )     76  
 
                       
Net income (loss)
  $ 622     $ 2,850     $ (386 )   $ 2,566  
 
                       
Net income (loss) per share:
                               
Basic
  $ 0.03     $ 0.14     $ (0.02 )   $ 0.13  
Diluted
  $ 0.03     $ 0.11     $ (0.02 )   $ 0.10  
Weighted average common shares outstanding:
                               
Basic
    20,410       20,198       20,356       20,031  
Diluted
    23,478       25,328       20,356       25,487  
 
The following table presents our historical operating results as a percentage of net revenues for the periods indicated:
                                 
    Three Months Ended   Nine Months Ended
    September 30,   September 30,
Statements of operations data (unaudited)   2006   2005   2006   2005
Net transaction revenues
    97.1 %     97.6 %     97.2 %     97.6 %
Referral and other revenues
    2.9       2.4       2.8       2.4  
 
                               
Net revenues
    100.0       100.0       100.0       100.0  
 
                               
Operating expenses:
                               
Cost of revenues
    54.4       55.1       54.7       55.0  
Product development
    4.9       2.7       5.3       2.7  
Marketing and customer acquisition
    11.9       12.9       13.0       13.5  
General and administrative
    30.3       21.5       31.6       22.0  
Litigation
                      5.8  
 
                               
Total operating expenses
    101.5       92.2       104.6       99.0  
 
                               
Income (loss) from operations
    (1.5 )     7.8       (4.6 )     1.0  
 
                               
Other income (expense):
                               
Interest income
    4.1       2.5       3.8       2.7  
Other expense, net
                       
 
                               
Total other income (expense), net
    4.1       2.5       3.8       2.7  
 
                               

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    Three Months Ended   Nine Months Ended
    September 30,   September 30,
Statements of operations data (unaudited)   2006   2005   2006   2005
Income (loss) before income taxes
    2.6       10.3       (0.8 )     3.7  
Provision for (benefit from) income taxes
    0.3       0.3       (0.2 )     0.1  
 
                               
Net income (loss)
    2.3 %     10.0 %     (0.6 )%     3.6 %
 
                               
                                 
    Three Months Ended   Nine Months Ended
    September 30,   September 30,
Other operating data   2006   2005   2006   2005
Number of ZipAgents at end of period
    1,747       1,383       1,747       1,383  
Total value of real estate transactions closed during period (in billions)
  $ 1.20     $ 1.36     $ 3.35     $ 3.42  
Number of transactions closed during period (1)
    3,467       3,689       9,657       9,407  
Average net revenue per transaction during period (2)
  $ 7,332     $ 7,475     $ 7,276     $ 7,454  
 
(1)   The term “transaction” refers to each representation of a buyer or seller in a real estate purchase or sale.
 
(2)   Average net revenue per transaction equals net transaction revenues divided by number of transactions with respect to each period.
Comparison of the three months ended September 30, 2006 and 2005
Net revenue
                                 
    Three Months Ended        
    September 30,   Increase   Percent
    2006   2005   (Decrease)   Change
    (in thousands)
Net revenue
  $ 26,185     $ 28,243     $ (2,058 )     (7.3 )%
     The decrease in our net revenues for the three months ended September 30, 2006 compared to the three months ended September 30, 2005 was primarily due to decreased transaction volume and by lower average net revenue per transaction. Transaction volume decreased by 6.0% and reduced revenue by $1.7 million resulting from 3,467 transactions closed in the three months ended September 30, 2006 compared to 3,689 transactions closed in the three months ended September 30, 2005. Our transaction volume decreased despite adding additional ZipAgents in our existing markets and continuing to add agents in our new markets in Las Vegas, Houston, Miami, Tampa, Orlando, Minneapolis/St. Paul, Austin and Palm Beach as we commenced operations in April 2005, June 2005, October 2005, February 2006, April 2006, May 2006, July 2006 and September 2006, respectively. Transaction volume from these new markets partially offset a decrease of 15.2% of the transactions closed in our existing markets. We had 1,747 ZipAgents at September 30, 2006 compared to 1,383 at September 30, 2005. Average net revenue per transaction decreased by 1.9% resulting in a decrease of $0.5 million primarily due to representing buyers and sellers in transactions in markets with lower home prices for the three months ended September 30, 2006. Referral and other revenues increased by 14.8% and contributed $0.1 million to offset the decrease in net revenues.
     We expect that our net revenues for 2006 will decrease modestly compared to the prior year. Transaction volume is expected to decline on a year-over-year basis in our existing markets, reflecting trends in the national housing market. Our average price per transaction may decline modestly due primarily to a growing percentage of transactions occurring in less expensive housing markets. Additionally, median home prices are declining in certain or our markets.
Cost of revenues
                                 
    Three Months Ended        
    September 30,   Increase   Percent
    2006   2005   (Decrease)   Change
    (in thousands)
Cost of revenues
  $ 14,238     $ 15,565     $ (1,327 )     (8.5 )%
     Our cost of revenues consists principally of commissions, related payroll taxes, benefits and expense allowances and reimbursements paid to our ZipAgents, and the amortization of internal-use software and website development costs which relate primarily to our ZAP technology.
     The decrease in cost of revenues for three months ended September 30, 2006 compared to the three months ended September 30, 2005 was due primarily to a decrease in commissions, associated payroll costs and expense allowances and reimbursements of

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approximately $1.4 million related to the decline in net transaction revenues, partially offset by a $0.1 million increase in stock-based compensation expense recognized as cost of revenues resulting from the adoption of SFAS No. 123(R). As a percentage of net revenues, cost of revenues decreased by 0.7 percentage points due primarily to the mix of commission splits earned by our Zip Agents.
     We expect that our cost of revenues for 2006 will be roughly comparable or decrease modestly compared to prior year in absolute dollars, but to remain relatively consistent or to increase modestly as a percentage of net revenues.
Product development
                                 
    Three Months Ended        
    September 30,   Increase   Percent
    2006   2005   (Decrease)   Change
    (in thousands)
Product development
  $ 1,284     $ 760     $ 524       69.0 %
     Product development expenses include our information technology costs, primarily compensation and benefits for our product development personnel, depreciation of equipment, communications expenses and other operating costs relating to the maintenance of our website and our proprietary technology systems.
     The increase in product development expenses for the three months ended September 30, 2006 compared to the three months ended September 30, 2005 was due to growth in our business and consisted of increases in salaries and benefits of approximately $0.3 million and information technology costs including depreciation of $0.2 million. As a percentage of net revenues, product development expenses increased by 2.2 percentage points in the period due primarily to the growth of the product development staff to enhance our proprietary consumer website and agent platform and to support our new market offices.
     We expect our product development expenses to increase in 2006 in absolute dollars and as a percentage of net revenues as we continue to grow our business and enhance our proprietary consumer website and agent platform.
Marketing and customer acquisition
                                 
    Three Months Ended        
    September 30,   Increase   Percent
    2006   2005   (Decrease)   Change
    (in thousands)
Marketing and customer acquisition
  $ 3,116     $ 3,637     $ (521 )     (14.3 )%
     Marketing and customer acquisition expenses include compensation and benefits of our marketing and client acquisition personnel and costs relating to our marketing, advertising and client acquisition activities.
     The decrease in marketing and customer acquisition expenses for the three months ended September 30, 2006 compared to the three months ended September 30, 2005 was due to a decrease in salaries and benefits of approximately $0.3 million and marketing and customer acquisition costs of approximately $0.2 million. As a percentage of net revenues, marketing and customer acquisition expenses decreased 1.0 percentage points in the period due primarily to holding the costs of customer lead acquisition flat.
     We expect our marketing and customer acquisition expenses to remain relatively consistent in absolute dollars and as a percentage of net revenues.
General and administrative
                                 
    Three Months Ended        
    September 30,   Increase   Percent
    2006   2005   (Decrease)   Change
    (in thousands)
General and administrative
  $ 7,922     $ 6,062     $ 1,860       30.7 %
     General and administrative expenses consist of compensation and benefits costs of our corporate employees, field support and management personnel, occupancy costs, legal and accounting fees, and other general operating support costs.

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     The increase in general and administrative expenses for the three months ended September 30, 2006 compared to the three months ended September 30, 2005 was due to growth in our business and consisted primarily of approximately $0.4 million related to increased salaries and benefits, $0.1 million of travel and $0.1 million of related occupancy and operating expenses for our additional management and support personnel in our existing and new district sales offices. Corporate office expenses increased for the same period due to approximately $0.6 million of salaries and benefits and approximately $0.2 million of occupancy and operating expenses, partially offset by a decrease in recruiting and training cost of $0.1 million. Additionally, stock-based compensation increased $0.5 million in general and administrative expense resulting from the adoption of SFAS No. 123(R). As a percentage of net revenues, general and administrative expenses increased 8.8 percentage points for the same period.
     As we continue to invest in our business and open new district sales offices we expect our general and administrative expenses to increase in absolute dollars and as a percentage of net revenues.
Interest income
                                 
    Three Months Ended        
    September 30,   Increase   Percent
    2006   2005   (Decrease)   Change
    (in thousands)
Interest income
    $1,086       $715     $ 371       51.8 %
 
     Interest income relates to interest we earn on our money market deposits and short-term investments. Interest income will fluctuate as our cash equivalents and short-term investment balances change and applicable interest rates increase or decrease. The increase in interest income for the three months ended September 30, 2006 compared to the three months ended September 30, 2005 was due primarily to higher interest rates earned on marginally lower average balances.
 
 
Other income (expense), net
                                 
    Three Months Ended        
    September 30,   Increase   Percent
    2006   2005   (Decrease)   Change
    (in thousands)
Other income (expense), net
    $(8)       $(8)     $       (6.4) %
 
     Other income (expense), net consists of non-operating items, which have not been significant to date.
 
 
Provision for income taxes
                                 
    Three Months Ended        
    September 30,   Increase   Percent
    2006   2005   (Decrease)   Change
    (in thousands)
Provision for income taxes
    $81       $76       $5       6.8 %
 
     We recorded a provision for income taxes in the three months ended September 30, 2006 and 2005 related to our net book profit based on our best estimate of the tax provision (benefit) that will be provided for the full year. At September 30, 2005, we maintained a full valuation allowance against our deferred tax assets based on the determination that it was more likely than not that the deferred tax assets would not be realized.
 
 
Comparison of the nine months ended September 30, 2006 and 2005
 
Net revenues
                                 
    Nine Months Ended        
    September 30,   Increase   Percent
    2006   2005   (Decrease)   Change
    (in thousands)
Net revenues
  $ 72,311     $ 71,818     $ 493       0.7 %
The increase in our net revenues for the nine months ended September 30, 2006 compared to the nine months ended September 30, 2005 was primarily due to increased transaction volume partially offset by lower average net revenue per transaction. Transaction

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volume increased by 2.7% and contributed $1.9 million resulting from 9,657 transactions closed in the nine months ended September 30, 2006 compared to 9,407 transactions closed in the nine months ended September 30, 2005. Our transaction volume increased as we added additional ZipAgents in our existing markets and continuing to add agents in our new markets in Las Vegas, Houston, Miami, Tampa, Orlando, Minneapolis/St. Paul, Austin and Palm Beach as we commenced operations in April 2005, June 2005, October 2005, February 2006, April 2006, May 2006, July 2006 and September 2006, respectively. Transaction volume from these new markets contributed 100.0% of the increased transactions closed in the nine months ended September 30, 2006 and offset a decrease of 6.7% of the transactions closed in our existing markets. We had 1,747 ZipAgents at September 30, 2006 compared to 1,383 at September 30, 2005. Average net revenue per transaction decreased by 2.4% resulting in a decrease of $1.7 million primarily due to representing buyers and sellers in transactions in markets with lower home prices for the nine months ended September 30, 2006. Referral and other revenues increased by 20.7% and contributed $2.0 million to net revenues.
Cost of revenues
                                 
    Nine Months Ended        
    September 30,   Increase   Percent
    2006   2005   (Decrease)   Change
    (in thousands)
Cost of revenues
  $ 39,568     $ 39,467     $ 101       0.3 %
     Our cost of revenues consists principally of commissions, related payroll taxes, benefits and expense allowances paid to our ZipAgents, and the amortization of internal-use software and website development costs which relate primarily to our ZAP technology.
     The increase in cost of revenues for the nine months ended September 30, 2006 compared to the nine months ended September 30, 2005 was due primarily to an increase in stock-based compensation of $0.3 million resulting from the adoption of SFAS No. 123(R), partially offset by a decrease in commissions, related payroll costs and expense allowances of approximately $0.2 million. As a percentage of net revenues, cost of revenues decreased by 0.3 percentage points in the period due primarily to the mix of commission splits earned by our ZipAgents.
Product development
                                 
    Nine Months Ended        
    September 30,   Increase   Percent
    2006   2005   (Decrease)   Change
    (in thousands)
Product development
  $ 3,838     $ 1,965     $ 1,873       95.3 %
Product development expenses include our information technology costs, primarily compensation and benefits for our product development personnel, depreciation of equipment, communications expenses and other operating costs relating to the maintenance of our website and our proprietary technology systems.
The increase in product development expenses for the nine months ended September 30, 2006 compared to the nine months ended September 30, 2005 was due to growth in our business and consisted of increases in salaries and benefits of approximately $1.2 million and information technology, including depreciation, of $0.5 million. Additionally, stock-based compensation increased $0.1 million resulting from the adoption of SFAS No. 123(R). As a percentage of net revenues, product development expenses increased by 2.6 percentage points in the period due primarily to the growth of our product development staff to enhance our proprietary consumer website, agent platform and overall system infrastructure.
Marketing and customer acquisition
                                 
    Nine Months Ended        
    September 30,   Increase   Percent
    2006   2005   (Decrease)   Change
    (in thousands)
Marketing and customer acquisition
  $ 9,413     $ 9,729     $ (316 )     (3.2 )%
     Marketing and customer acquisition expenses include compensation and benefits of our marketing and customer acquisition personnel and costs relating to our marketing, advertising and client acquisition activities.

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     The decrease in marketing and customer acquisition expenses in the nine months ended September 30, 2006 compared to the nine months ended September 30, 2005 was primarily due to a decrease in salaries and benefits of $0.4 million, partially offset by a increased in customer acquisition and marketing costs of approximately $0.1 million. As a percentage of net revenues, marketing and customer acquisition expenses for the same periods decreased 0.5 percentage points in the period due primarily to a reduction in headcount in the marketing department.
General and administrative
                                 
    Nine Months Ended        
    September 30,   Increase   Percent
    2006   2005   (Decrease)   Change
    (in thousands)
General and administrative
    $22,831       $15,807       $7,024       44.4 %
 
     General and administrative expenses consist of compensation and benefits costs of our corporate employees, field support and management personnel, occupancy costs, legal and accounting fees, and other general operating support costs.
 
     The increase in general and administrative expenses in the nine months ended September 30, 2006 compared to the nine months ended September 30, 2005 was due to growth in our business and consisted primarily of approximately $1.5 million related to increased salaries and benefits, $0.2 million of travel, $0.2 million of depreciation and $0.6 million of related occupancy, communication and operating costs for our additional management and support personnel in our existing and new district sales offices. These costs were partially offset by a decrease of approximately $0.3 million related to recruiting and training expenses. Corporate office expenses increased for the same period due to approximately $2.2 million of salaries and benefits, approximately $0.7 million of outside accounting and other professional costs relating primarily to operating as a public company including Sarbanes-Oxley section 404 compliance costs and approximately $0.6 million of depreciation, occupancy and other operating costs related primarily to the relocation of our corporate office. Additionally, stock-based compensation increased $1.2 million in general and administrative expense resulting from the adoption of SFAS No. 123(R). As a percentage of net revenues, general and administrative expenses increased 9.6 percentage points for the same period.
 
 
Litigation
 
    Nine Months Ended        
    September 30,   Increase   Percent
    2006   2005   (Decrease)   Change
    (in thousands)
Litigation
  $       $4,164     $ (4,164 )     (100.0 )%
 
     Litigation expense in 2005 is related to a class action lawsuit. We settled this claim in exchange for our payment of $4.164 million.
 
Interest income
 
    Nine Months Ended        
    September 30,   Increase   Percent
    2006   2005   (Decrease)   Change
    (in thousands)
Interest income
    $2,782       $1,967       $815       41.4 %
 
     Interest income relates to interest we earn on our money market deposits and short-term investments. Interest income will fluctuate as our cash equivalents and short-term investment balances change and applicable interest rates increase or decrease. The increase in interest income for the nine months ended September 30, 2006 compared to the nine months ended September 30, 2005 was due primarily to higher interest rates earned on marginally lower average balances.
 
Other income (expense), net
 
    Nine Months Ended        
    September 30,   Increase   Percent
    2006   2005   (Decrease)   Change
    (in thousands)
Other income (expense), net
    $(8)       $(11)       $3       27.1 %

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     Other income (expense), net consists of non-operating items, which have not been significant to date.
Provision for income taxes
                                 
    Nine Months Ended        
    September 30,   Increase   Percent
    2006   2005   (Decrease)   Change
    (in thousands)
Provision for income taxes
  $ (179 )   $ 76     $ (255 )     (336.8 )%
     We recorded a benefit from income taxes in the nine months ended September 30, 2006 related to our net book income based on our best estimate of the tax provision (benefit) that will be provided for the full year. We recorded a provision for income taxes in the nine months ended September 30, 2005 attributable to federal and state alternative minimum taxes payable due primarily to limits on the amount of net operating losses that could be applied against income earned in 2005 under current tax regulations. At September 30, 2005, we maintained a full valuation allowance against our deferred tax assets based on the determination that it was more likely than not that the deferred tax assets would not be realized.
LIQUIDITY AND CAPITAL RESOURCES
     Prior to our initial public offering in November 2004, we funded our operations primarily through the sale of preferred stock and convertible notes, which provided us with aggregate net proceeds of approximately $65.8 million. In November 2004, we completed our initial public offering, which raised net proceeds, after underwriting discounts, commissions and expenses, of approximately $61.4 million.
     As of September 30, 2006, we had cash, cash equivalents and short-term investments of $88.4 million and had no bank debt, line of credit or equipment facilities.
Operating activities
     Our operating activities generated cash in the amount of $1.8 million and $8.1 million in the nine months ended September 30, 2006 and 2005, respectively. Cash generated in the nine months ended September 30, 2006 resulted from a net loss of $0.4 million, which was offset primarily by $1.8 million of depreciation and amortization, $1.9 million of non-cash stock-based compensation expense and by changes in working capital, primarily the remaining payment of $3.2 million for litigation settlement. Cash generated in the nine months ended September 30, 2005 was primarily due to growth in our business and additionally to the accrual of $4.2 million for litigation settlement.
     Our primary source of operating cash flow is the collection of our commission income from escrow companies or similar intermediaries in the real estate transaction closing process. Due to the structure of our commission arrangements, our accounts receivable are converted to cash on a short-term basis and our accounts receivable balances at period end have historically been significantly less than one month’s net revenues. Our operating cash flows will be impacted in the future by the timing of payments to our vendors for accounts payable, which are generally paid within the invoice terms and conditions. Our cash outflows are also impacted by the timing of the payment of our accrued liabilities relating to commissions and related compensation costs and client acquisition costs.
     A number of non-cash items have been charged to expense and decreased our net income or increased our net loss. These items include depreciation and amortization of property and equipment and non- cash employee stock-based compensation expense and other stock-based charges. To the extent these non-cash items increase or decrease in amount and increase or decrease our future operating results, there will be no corresponding impact on our cash flows.
Investing activities
     Our investing activities generated cash in the amount of $0.2 million and used cash in the amount of $12.4 million in the nine months ended September 30, 2006 and 2005, respectively. Sources of cash for the nine months ended September 30, 2006 represent net proceeds from the sales and purchase of short-term investments partially offset by the purchase of property and equipment, furniture, and leasehold improvements in connection with the relocation and build-out of the corporate and new district office spaces. Uses of cash for the nine months ended September 30, 2005 were primarily related to purchases of short-term investments and purchases of property and equipment.

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     We primarily maintain a minimum amount of cash and cash equivalents for operational purposes and invest the remaining amount of our cash in investment grade, highly liquid interest-bearing securities which allows for flexibility in the event our cash needs change.
     Currently, we expect our remaining 2006 capital expenditures to be approximately $0.7 million. Capital expenditures for the remainder of 2006 are expected to include increased server capacity and purchase of computer equipment and software. In the future, our ability to make significant capital investments may depend on our ability to generate cash flow from operations and to obtain adequate financing, if necessary and available.
Financing activities
     Our financing activities provided cash in the amount of $0.5 million and $0.5 million in the nine months ended September 30, 2006 and 2005, respectively. Sources of cash from financing activities primarily represented proceeds from common stock option exercises.
     As of September 30, 2006, we had warrants outstanding for the purchase of an aggregate of 4,603,000 shares of our common stock at a weighted average exercise price of $3.94 per share. All of these warrants are currently exercisable at the option of the holders. If all or a portion of these warrants were exercised for cash, we could receive significant proceeds at that time.
Future needs
     We believe that cash flows from operations and our current cash, cash equivalents and short-term investments will be sufficient to fund our operations for at least the next 12 months. Our future capital requirements will depend on many factors, including our rate of growth into new geographic markets, our level of investment in technology and advertising initiatives. We are currently exploring several options for offering services relating to the purchase, sale and ownership of a home, including services related to title insurance, escrow, mortgage, home warranty insurance and property and casualty insurance (including auto insurance), which we refer to as core services. We expect that some of our core services will be offered through affiliates (including wholly owned subsidiaries), while others will be offered through joint ventures or marketing arrangements with independent third parties, such as title companies, banks and insurance companies. We may enter into these types of arrangements in the future, which could also require us to seek additional equity or debt financing. We currently have no bank debt or line of credit facilities. In the event that additional financing is required, we may not be able to raise it on terms acceptable to us or at all. If we are unable to raise additional capital when desired, our business, operations and results will likely suffer.
CONTRACTUAL OBLIGATIONS AND COMMITMENTS
     We lease office space under non-cancelable operating leases with various expiration dates through January 2012. The following table provides summary information concerning our future contractual obligations and commitments at September 30, 2006.
                                         
    Payments due by period
    Less than                   More than    
    1 year   1 to 3 years   3 to 5 years   5 years   Total
    (in thousands)
Operating lease commitments
  $ 1,551     $ 2,290     $ 1,458     $ 241     $ 5,540  
OFF-BALANCE SHEET ARRANGEMENTS
     We do not have any off balance-sheet arrangements, investments in special purpose entities or undisclosed borrowings or debt. Additionally, we are not a party to any derivative contracts or synthetic leases.
Item 3. Quantitative and Qualitative Disclosures About Market Risk:
Interest rate sensitivity
     We have minimal interest rate exposure on our investments. Our investment policy requires us to invest funds in excess of current operating requirements. The principal objectives of our investment activities are to preserve principal, provide liquidity and maximize income consistent with minimizing risk of material loss.

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     As of September 30, 2006 and 2005, our cash and cash equivalents consisted primarily of money market funds and our short-term investments consisted primarily of investment grade, highly liquid interest-bearing securities. The recorded carrying amounts of cash and cash equivalents approximate fair value due to their short maturities and short-term investments are carried at fair value. The amount of credit exposure to any one issue, issuer and type of instrument is limited. Our interest income is sensitive to changes in the general level of interest rates in the United States, particularly since the majority of our investments are fixed income investments. If market interest rates were to increase or decrease immediately and uniformly by 10% from levels at September 30, 2006 and 2005, the increase or decline in fair market value of the portfolio would be approximately $0.4 million and $0.2 million, respectively.
Exchange rate sensitivity
     We consider our exposure to foreign currency exchange rate fluctuations to be minimal, as we do not have any sales denominated in foreign currencies. We have not engaged in any hedging or other derivative transactions to date.
Item 4. Controls and Procedures:
     (a) Disclosure controls and procedures. Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as such items are defined in Rule 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (“Exchange Act”)) as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer has concluded that our disclosure controls and procedures as of the end of the period covered by this Quarterly Report are effective to ensure that information we are required to disclose in reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure, and that such information is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.
     (b) Changes in internal control over financial reporting. There were no changes in our internal control over financial reporting during the quarter ended September 30, 2006 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
PART II — OTHER INFORMATION
Item 1. Legal Proceedings:
     We are not currently subject to any material legal proceedings. From time to time we have been, and we currently are, a party to litigation and subject to claims incident to the ordinary course of our business. The amounts in dispute in these matters are not material to us, and we believe that the resolution of these proceedings will not have a material adverse effect on our business, results of operations, financial position, or cash flows.
Item 1A. Risk Factors:
     Because of the following factors, as well as other variables affecting our operating results and financial condition, past financial performance may not be a reliable indicator of future performance, and historical trends should not be used to anticipate results or trends in future periods.
RISKS RELATED TO OUR BUSINESS AND INDUSTRY
We have been profitable in only nine quarters and may incur losses in the future, and our limited operating history makes our future financial performance difficult to assess.
     We were formed in January 1999 and therefore have a limited operating history upon which to evaluate our operations and future prospects. We have had a history of losses from inception through the first half of 2003 and at September 30, 2006 had an accumulated deficit of $32.0 million. While we were profitable in the third and fourth quarters of 2003, the second, third and fourth quarters of 2004, the first, third and fourth quarters of 2005 and the third quarter of 2006, we may not be profitable in future quarters or on an annual basis. While we experienced a net loss in the second quarter of 2005 as a result of a one-time charge relating to the settlement of a threatened class action lawsuit, we would have been profitable excluding the effect of this settlement. Our outlook is

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cautious for the balance of the year given market and geopolitical uncertainties, and we may experience a loss for calendar year 2006 as we continue to invest in our business during this period of market softness.
     Our business model has evolved, and we have only recently achieved significant revenues. We may incur additional expenses with the expectation that our revenues will grow in the future, which may not occur. As a result, we could experience budgeting and cash flow management problems, unexpected fluctuations in our results of operations and other difficulties, any of which could harm our ability to achieve or maintain profitability, increase the volatility of the market price of our common stock or harm our ability to raise additional capital. Additionally, as a public company we must work towards continued compliance with the requirements of the Securities and Exchange Commission, NASDAQ and the Sarbanes-Oxley Act of 2002, and we may incur costs in connection with that effort that are significantly higher than anticipated, which could negatively impact our profitability.
     We expect that we will continue to increase our expenses, including marketing and customer acquisition expenses and expenses incurred as a result of increasing the number of agents we employ. As we grow our business in existing markets and expand to new markets, we cannot guarantee our business strategies will be successful or that our revenues will ever increase sufficiently to achieve and maintain profitability on a quarterly or annual basis.
Our business model requires access to real estate listing services provided by third parties that we do not control, and the demand for our services may be reduced if our ability to display listings on our website is restricted.
     A key component of our business model is that through our website we offer clients access to, and the ability to search, real estate listings posted on the MLSs in the markets we serve. Most large metropolitan areas in the United States have at least one MLS, though there is no national MLS. The homes in each MLS are listed voluntarily by its members, who are licensed real estate brokers. The information distributed in an MLS allows brokers to cooperate in the identification of buyers for listed properties.
     If our access to one or more MLS databases, or our ability to offer our clients the ability to access and search listings on one or more MLSs, were restricted or terminated, our service could be adversely affected and our business may be harmed. Because participation in an MLS is voluntary, a broker or group of brokers may decline to post their listings to the existing MLS and instead create a new proprietary real estate listing service. If a broker or group of brokers created a separate real estate listing database, we may be unable to obtain access to that private listing service on commercially reasonable terms, if at all. As a result, the percentage of available real estate listings that our clients would be able to search using our website would be reduced, perhaps significantly, thereby making our services less attractive to potential clients.
     Additionally, we operate a virtual office website, or VOW, which is a password protected website that allows us to show comprehensive MLS data directly to consumers without their having to visit an agent. In late 2002, the National Association of Realtors, or NAR, the dominant trade organization in the residential real estate industry, adopted a mandatory policy for NAR-affiliated MLSs regarding the use and display of MLS listings data on VOWs. Under the NAR policy, individual MLSs affiliated with NAR, which includes the vast majority of MLSs in the United States, were required to implement their own individual VOW policies consistent with the NAR, but NAR extended the deadline for the implementation of its rules at least three times during an investigation by the Antitrust Division of the U.S. Department of Justice, or DOJ, into NAR’s policy that dictates how brokers can display other brokers’ property listings on their websites. In September 2005, NAR replaced its VOW policy with an Internet Listings Display, or ILD, policy containing some of the same or similar features of its former VOW policy, and the DOJ responded by immediately filing a lawsuit in federal court against NAR challenging the ILD policy. NAR has postponed the deadline for the implementation of its ILD rules by its member MLSs pending resolution of that lawsuit. We presently do not know whether or when the NAR rules will be implemented in their current form or in a revised form, if at all. Once the individual MLSs implement the ILD policy, the NAR policy currently provides that member brokerages will have up to 90 days to comply with the policy.
     The NAR policy is designed to provide structure to the individual MLS policies concerning the display of listing information through the internet, subject to a number of areas in which the individual MLSs may tailor the policy to meet their local needs. One NAR policy provision with which the individual MLSs must adhere, once required to be implemented, is known as an “opt-out.” This provision creates a mechanism for individual brokers to prevent their listings data from being displayed by competitors on their websites but not by brick-and-mortar competitors at their offices by other means, which the DOJ has alleged is a mechanism designed to chill competition by internet-based realtors.
     A few of the MLSs of which we are a member, as well as at least one of the state Association of REALTORS® of which we are a member, had adopted VOW policies with opt-out provisions, but, to our knowledge, to date no members or participants of any of those MLSs have exercised such an opt-out right. We do not know of any MLSs which have adopted the new ILD policy with its opt-

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out provisions. Should any such opt-outs right be exercised, it could restrict our ability to display comprehensive MLS home listings data to our consumers, which is a key part of our business model. Should our ability to display MLS listings information on our website be significantly restricted, it may reduce demand for our services and lead to a decrease in the number of residential real estate transactions completed by our ZipAgents, as well as increase our costs of ensuring compliance with such restrictions.
Our business could be harmed by transitions in the real estate markets and economic events that are out of our control and may be difficult to predict.
     The success of our business depends in part on the health of the residential real estate market, which traditionally has been subject to cyclical economic swings as well as other changes in local regional or national economic conditions. The purchase of residential real estate is a significant transaction for most consumers, and one which can be delayed or terminated based on the availability of discretionary income. Economic slowdown or recession, rising interest rates, adverse tax policies or changes in other regulations, lower availability of credit, increased unemployment, lower consumer confidence, lower wage and salary levels, war or terrorist attacks, natural disaster, oil price spikes or the public perception that any of these events may occur, could adversely affect the demand for residential real estate and would harm our business. Also, if interest rates increase significantly, homeowners’ ability to purchase a new home or a higher priced home may be reduced as higher monthly payments would make housing less affordable. In addition, these conditions could lead to a decline in transaction volume and sales prices, either of which would harm our operating results.
     Since early September of 2005 we have experienced a significant increase in the available inventory of homes for sale in many of our markets, as well as an increase in the amount of time listings are taking to sell. Pricing increases have also slowed, and some markets have shown declines in median selling prices over this period. Nationally, sales of existing homes fell 14.2% year-over-year in September 2006 to a seasonally adjusted annual rate 6.18 million. In the State of California, the California Association of REALTORS reported that sales of existing homes declined 31.7% year-over-year during the month of September 2006. In our opinion, these data points suggest the housing market is in a period of transition, with more power shifting to buyers from sellers, which may impair our ability to grow the Company and our agent productivity.
Interest rates were at historic lows for the past several years, and increases in interest rates have the potential to negatively impact the housing market.
     Since the fall of 2005, the residential real estate market has been softening as interest rates have been increasing. When interest rates rise, all other things being equal, housing becomes less affordable, since at a given income level people cannot qualify to borrow as much principal, or given a fixed principal amount they will be faced with higher monthly payments. This result may mean that fewer people will be able to afford homes at prevailing prices, potentially leading to fewer transactions or reductions in home prices in certain regions, depending also on the relevant supply-demand dynamics of those markets. Since we operate in only 20 markets around the country, it is possible that we could experience a more pronounced impact than we would experience if our operations were more diversified. Should we experience continued softness in our markets and not be able to offset the potential negative market influences on price and volume by increasing our transaction volume through market share growth, our financial results could be negatively impacted.
Our business model is new and unproven, and we cannot guarantee our future success.
     Our Internet-enabled residential real estate brokerage service is a relatively new and unproven business model. Our business model differs significantly from that of a traditional real estate brokerage firm in several ways, including our heavy reliance on the Internet and technology and our employee agent model. The success of our business model depends on its scalability and on our ability to achieve higher transaction volumes at an overall lower cost per transaction in order to offset the costs associated with our technology, employee benefits, marketing and advertising expenses and discounts and rebates. If we are unable to efficiently acquire clients and maintain agent productivity in excess of industry averages, our ZipAgents may close fewer transactions and our net revenues could suffer as a result. Also, given that our agent employee model is uncommon in the real estate industry, our compensation structure could be subject to legal challenge, such as the litigation commenced against ZipRealty in 2005, which has been resolved. In addition, our agents generally earn a lower per transaction commission than a traditional independent contractor agent. If we are unsuccessful in providing our agents with an attractive value proposition, whether through more opportunities to close transactions or otherwise, when compared to the traditional model, our ability to hire and retain qualified real estate agents would be harmed, which would in turn significantly harm our business.
If we fail to recruit, hire and retain qualified agents, we may be unable to service our clients and our growth could be impaired.

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     Our business requires us to hire employees who are licensed real estate agents, and our strategy is based on consistently and rapidly growing our team of ZipAgents. Competition for qualified agents is intense, particularly in the markets in which we compete, and retention is an industry-wide issue. While there are many licensed real estate agents in our markets and throughout the country, historically we have had difficulties in recruiting and retaining properly qualified licensed agents due particularly to agent discomfort with using technology and being actively managed by an employer. In addition, our lower per transaction agent commission model may be unattractive to certain higher performing agents. If we are unable to recruit, train and retain a sufficient number of qualified licensed real estate agents, we may be unable to service our clients properly and grow our business.
     Historically we have experienced a high degree of agent turnover, most of which occurs in the first few months after commencing employment. This turnover has required us to expend a substantial amount of time and money to replace agents who have left as we have been growing our business. If this situation worsens, our rate of expansion into new markets could be slowed and we will continue to employ a significantly higher number of new agents with less experience operating in our business model, which could cause us to be less effective at expanding our market share in our existing markets and entering new markets.
     Furthermore, we rely on federal and state exemptions from minimum wage and fair labor standards laws for our ZipAgents, who are compensated primarily through commissions. Such exemptions may not continue to be available, or we may not qualify for such exemptions, which could subject us to penalties and damages for non-compliance. Also, some states, such as California, have enacted laws requiring the reimbursement of employee expenses, which caused us to change our compensation practices in 2005. If similar exemptions are not available in states where we desire to expand our operations or if they cease to be available in the states where we currently operate, or if we are so required by other state laws, we may need to modify our agent compensation structure in such states, which could cause our compensation practices to be less attractive to agents or more expensive to the Company.
Our failure to effectively manage the growth of our ZipAgents and related technology could adversely affect our ability to service our clients.
     As our operations have expanded, we have experienced rapid growth in our headcount from 1,572 total employees, including 1,383 ZipAgents, at September 30, 2005 to 1,963 total employees, including 1,747 ZipAgents, at September 30, 2006. We expect to continue to increase headcount in the future, particularly the number of ZipAgents. Our rapid growth has demanded, and will continue to demand, substantial resources and attention from our management. We will need to continue to hire additional qualified agents and improve and maintain our related technology to properly manage our growth. If we do not effectively manage our growth, our client service and responsiveness could suffer and our costs could increase, which could negatively affect our brand and operating results.
Our failure to effectively manage the growth of our control systems could adversely affect our ability to maintain legal compliance.
     As we grow, our success will depend on our ability to continue to implement and improve our operational, financial and management information and control systems on a timely basis, together with maintaining effective cost controls. This ability is particularly critical as we implement new systems and controls to help us better comply with the stringent requirements of being a public company, including the requirements of the Sarbanes-Oxley Act of 2002, which require management to evaluate and assess the effectiveness of our internal control over financial reporting and our disclosure controls and procedures. Effective internal control over financial reporting is required by law and is necessary for us to provide reliable financial reports and effectively prevent fraud. Effective disclosure controls and procedures are required by law and are necessary for us to file complete, accurate and timely reports under the Securities Exchange Act of 1934. Our ability to manage the growth of our control systems and maintain legal compliance could be thwarted by many factors, including turnover in management and the lack of adequate staffing with the requisite expertise and training. Any inability to provide reliable financial reports or prevent fraud or to file complete, accurate and timely reports under the Securities Exchange Act could harm our business, harm our reputation or result in a decline in our stock price. We are continuing to evaluate and, where appropriate, enhance our systems, procedures and internal controls. If our systems, procedures or controls are not adequate to support our operations and reliable, accurate and timely financial and other reporting, we may not be able to successfully satisfy regulatory and investor scrutiny, offer our services and implement our business plan.
If we fail to comply with real estate brokerage laws and regulations, we may incur significant financial penalties or lose our license to operate.
     Due to the geographic scope of our operations and the nature of the real estate services we perform, we are subject to numerous federal, state and local laws and regulations, and regulatory authorities have relatively broad discretion to grant, renew and revoke licenses and approvals and implement regulations. For example, we are required to maintain real estate brokerage licenses in each

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state in which we operate and to designate individual licensed brokers of record. In some states, these licenses are personal to the broker. If we fail to maintain our licenses, lose the services of our designated broker of record or conduct brokerage activities without a license, we may be required to pay fines or return commissions received, our licenses may be suspended or revoked or not renewed or we may be subject to other civil and/or criminal penalties. As we expand into new markets, we will need to obtain and maintain the required brokerage licenses, which may be difficult, and comply with the applicable laws and regulations of these markets, which may be different from those to which we are accustomed, any of which will increase our compliance costs. In addition, because the size and scope of real estate sales transactions have increased significantly during the past several years, both the difficulty and cost of compliance with the numerous state licensing regimes and possible losses resulting from non-compliance have increased. Our failure to comply with applicable laws and regulations, the possible loss of real estate brokerage licenses or litigation by government agencies or affected clients may have a material adverse effect on our business, financial condition and operating results, and may limit our ability to expand into new markets.
We may have liabilities in connection with real estate brokerage activities.
     As a licensed real estate brokerage, we and our licensed employees are subject to statutory due diligence, disclosure and standard-of-care obligations. In the ordinary course of business we and our employees are subject to litigation from parties involved in transactions for alleged violations of these obligations. We self-insure some of this risk and, as we expand our business to include larger deals, we may not be able or otherwise determine not to obtain third party insurance on these larger deals with attractive terms. In addition, we may be required to indemnify our employees who become subject to litigation or other claims arising out of our business activities, including for claims related to the negligence of those employees. An adverse outcome in any such litigation could negatively impact our reputation and harm our business.
We may have liabilities if any of our employees violates laws concerning settlement procedures.
     Our business must comply with the provisions of the federal Real Estate Settlement Procedures Act, or RESPA, as well as comparable state statutes where we do business. These statutes, among other things, restrict payments which real estate brokers, agents and other settlement service providers may receive for referral of business to other settlement service providers in connection with the closing of real estate transactions. RESPA and similar state laws also require timely disclosure of certain relationships or financial interest that a broker has with providers of real estate settlement services. If any of our employees fails to comply with any of these statutes, a resulting enforcement proceeding could subject us to substantial financial penalties, be expensive to defend and materially harm our ability to continue operations.
If any of our core services fails to comply with applicable federal and state law and regulations, we may incur significant financial penalties or lose licenses require to provide these services.
     We are currently exploring and beginning to implement several options for offering services relating to the purchase, sale and ownership of a home, including services related to title insurance, escrow, mortgage, home warranty insurance and property and casualty insurance (including auto insurance), which we refer to as core services. We expect that some of our core services will be offered through affiliates (including wholly owned subsidiaries), while others will be offered through joint ventures or marketing arrangements with independent third parties, such as title companies, banks and insurance companies. For example, as discussed above, we have entered into a co-marketing arrangement with E-LOAN, Inc. to provide the mortgage center on our website in exchange for a flat monthly fee established on a periodic basis. Also, we have formed a joint venture with a title insurance company to offer our clients title insurance service in one or more of our markets, and we have formed a subsidiary to offer insurance services in certain markets.
     These core services may be subject to regulation at both the federal and state level, including, in certain instances, regulation under the Fair Housing Act, the Real Estate Settlement Procedures Act, or RESPA, state and local licensing laws and regulations (whether applicable to us or third parties with whom we have arrangements) and federal and state advertising laws, fair lending and insurance-related laws and regulations. Some of these laws and regulations, such as RESPA, do not offer definitive requirements for compliance, making it difficult to determine conclusively whether these core services will comply. The laws of the states in which we conduct business often vary considerably regarding the legality of and licensing requirements for conducting certain business practices, including the payment of compensation, in connection with offering mortgage, title insurance and other insurance products, and these states often do not provide definitive guidance concerning when these practices are illegal or require licensure, which can make it difficult to determine whether our practices are in legal compliance. In addition, to the extent that these core services are offered through affiliates or arrangements with independent third parties, we may have little ability to ensure that these parties comply with applicable laws and regulations. Also, as these core services are expanded into new markets, they will need to obtain and maintain the

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required licenses and comply with the applicable laws and regulations of these markets, which may be different from the laws and regulations to which they were previously subject, may be difficult to obtain and will increase compliance costs.
     If our practices in offering these core services fail to comply with applicable laws and regulations (including if they fail to maintain any necessary licenses, whether through the loss of individuals or entities licensed to perform these services or otherwise, or if they are performed or compensated without required licenses), we and the other parties providing the core services may be required to pay fines or return commissions received and may be subject to other civil or criminal penalties under actions by government agencies or clients, and the licenses needed to provide these core services may be suspended, revoked or denied. Any of these events could also cause disruption in the relationships between us and the other parties involved in offering these core services. Consequently, any failure to comply with application laws and regulations may have a material adverse effect on our business, financial condition and operating results, and may limit our ability to expand our core services into new markets.
We may have liabilities in connection with our performance of core services.
     For some of the core services we anticipate offering, such as insurance and mortgage, we expect the performance of these core services to be subject to statutory due diligence, disclosure and standard-of-care obligations. In the ordinary course of business, we and the other parties involved in providing these core services may be subject to litigation from clients and other parties involved in transactions for alleged violations of these obligations. We anticipate that the vehicles providing these core services will self-insure some of this risk. In addition, these vehicles may be required to indemnify their employees who become subject to litigation or other claims arising out of their business activities, including for claims related to the negligence of these employees. An adverse outcome in any such litigation could negatively impact our reputation and harm our business.
If our arrangements for providing core services become impaired, we may lose sources of revenue that may be difficult to replace and we may be less likely to engage in related transactions with our clients.
     As mentioned above, we are currently exploring several options for offering core services, and we expect that some of these services will be offered through affiliates (including wholly owned subsidiaries), while others will be offered through joint ventures or marketing arrangements with independent third parties, such as title companies, banks and insurance companies. If these relationships are terminated or otherwise become impaired, we could lose sources of revenues that we may not be able to readily replace, and our clients could have a more difficult time obtaining services they require in connection with their purchase or sale of a home, reducing our likelihood of engaging in residential real estate or other transaction with these clients. For example, we receive revenues from our marketing relationship with E-LOAN, Inc., which provides the ZipRealty Mortgage Center on our website and pays us a flat monthly fee that is established on a periodic basis (representing less than 3% of our revenues during fiscal year 2005). E-LOAN was acquired by Popular, Inc. in late 2005. If our marketing relationship with E-LOAN became impaired, not only would be lose the marketing revenues from that relationship, but also our clients could have a more difficult time obtaining the financing needed to purchase a home through us, which could negatively impact our transaction revenues. In addition, upon the termination of an arrangement with an independent third party to provide core services, we or our affiliates may be required to pay certain costs or fees or be precluded from performing such services for a period of time. Any of these events could negatively impact our business and financial condition.
If consumers do not continue to use the Internet as a tool in their residential real estate buying or selling process, we may be unable to attract new clients and our growth and financial results may suffer.
     We rely substantially on our website and web-based marketing for our client lead generation. As the residential real estate business has traditionally been characterized by personal, face-to-face relationships between buyers and sellers and their agents, our success will depend to a certain extent on the willingness of consumers to increase their use of online services in the real estate sales and purchasing process. In addition, our success will depend on consumers visiting our website early in their selling or buying process so that we can interface with potential clients before they have engaged a real estate agent to represent them in their transactions. If we are unable to convince visitors to our website to transact business with us, our ZipAgents will have fewer opportunities to represent clients in residential real estate transactions and our net revenues could suffer.
Our success depends in part on our ability to successfully expand into additional real estate markets.
     We currently operate in 20 markets, including 15 of the 25 most populous U.S. metropolitan statistical areas. A part of our business strategy is to grow our business by entering into additional real estate markets and, to this end, we commenced operations in Las Vegas in April 2005, in Houston in June 2005, in Miami in October 2005, in Tampa in February 2006, in Orlando in April 2006,

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in Minneapolis/St. Paul in May 2006, in Austin in July 2006, and in Palm Beach in September 2006. We have announced plans to also enter the Greater Philadelphia area in 2006 and Naples and Tucson in the first quarter of 2007. Key elements of this expansion include our ability to identify strategically attractive real estate markets and to successfully establish our brand in those markets. We consider many factors when selecting a new market to enter, including:
    the economic conditions and demographics of a market;
 
    the general prices of real estate in a market;
 
    Internet use in a market;
 
    competition within a market from local and national brokerage firms;
 
    rules and regulations governing a market;
 
    the ability and capacity of our organization to manage expansion into additional geographic areas, additional headcount and increased organizational complexity;
 
    the existence of local MLSs; and
 
    state laws governing cash rebates and other regulatory restrictions.
     Before opening Las Vegas we had not entered a new geographic market since July 2000 and have limited experience expanding into and operating in multiple markets, managing multiple sales regions or addressing the factors described above. In addition, this expansion could involve significant initial start-up costs. We expect that significant revenues from new markets may be achieved, if ever, only after we have been operating in that market for some time and begun to build market awareness of our services. As a result, geographic expansion is likely to significantly increase our expenses and cause fluctuations in our operating results. In addition, if we are unable to successfully penetrate these new markets, we may continue to incur costs without achieving the expected revenues, which would harm our financial condition and results of operations.
Unless we develop, maintain and protect a strong brand identity, our business may not grow and our financial results may suffer.
     We believe a strong brand is a competitive advantage in the residential real estate industry because of the fragmentation of the market and the large number of agents and brokers available to the consumer. Because our brand is relatively new, we currently do not have strong brand identity. We believe that establishing and maintaining brand identity and brand loyalty is critical to attracting new clients. In order to attract and retain both clients and employees, and respond to competitive pressures, we expect to increase our marketing and customer aquisition expenditures to develop, maintain and enhance our brand in the future.
     We plan to continue conducting and refining online and direct mail advertising and possibly to test and conduct print, radio, outdoor campaigns. We plan to increase our online advertising expenditures in the near future. While we intend to enhance our marketing and advertising activities in order to attract and retain both clients and employees, these activities may not have a material positive impact on our brand identity. In addition, developing our brand will depend on our ability to provide a high-quality consumer experience and high quality service, which we may not do successfully. If we are unable to develop, maintain and enhance our brand, our ability to attract new clients and employees or successfully expand our operations will be harmed.
We have numerous competitors, many of which have valuable industry relationships, innovative business models and access to greater resources than we do.
     The residential real estate market is highly fragmented, and we have numerous competitors, many of which have greater name recognition, longer operating histories, larger client bases, and significantly greater financial, technical and marketing resources than we do. Some of those competitors are large national brokerage firms or franchisors, such as Prudential Financial, Inc., RE/MAX International Inc. and Realogy Corporation (recently spun off from Cendant Corporation), which owns the Century 21, Coldwell Banker and ERA franchise brands, a large corporate relocation business and NRT Incorporated, the largest brokerage in the United States. NRT owns and operates brokerages that are typically affiliated with one of the franchise brands owned by Realogy. We are also subject to competition from local or regional firms, as well as individual real estate agents. Our technology-focused business

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model is a relatively new approach to the residential real estate market and many consumers may be hesitant to choose us over more established brokerage firms employing traditional techniques.
     Some of our competitors are able to undertake more extensive marketing campaigns, make more attractive offers to potential agents and clients and respond more quickly to new or emerging technologies. Over the past several years there has been a slow but steady decline in average commissions charged in the real estate brokerage industry, with the average commission percentage decreasing from 5.44% in 2000 to 5.02% in 2005 according to REAL Trends. Some of our competitors with greater resources may be able to better withstand the short- or long-term financial effects of this trend. In addition, the barriers to entry to providing an Internet-enabled real estate service are low, making it possible for current or new competitors to adopt certain aspects of our business model, including offering comprehensive MLS data to clients via the Internet, thereby reducing our competitive advantage. We may not be able to compete successfully for clients and agents, and increased competition could result in price reductions, reduced margins or loss of market share, any of which would harm our business, operating results and financial condition.
     We also compete or may in the future compete with various online services, such as InterActiveCorp and its LendingTree unit, HouseValues, Inc., HomeGain, Inc., Homestore, Inc. and its Realtor.com affiliate, Zillow and Yahoo! Inc. that also look to attract and monetize home buyers and sellers using the Internet. Homestore is affiliated with NAR, the National Association of Home Builders, or NAHB, and a number of major MLSs, which may provide Homestore with preferred access to listing information and other competitive advantages. In addition, the competitive landscape in the residential real estate industry is in the midst of significant changes as new business models enter the marketplace. In order to continue growing, our business model must remain attractive to consumers so that we can compete successfully with these newer models as they expand into our marketplaces
     In addition, the competitive landscape in the residential real estate industry is in the midst of significant changes as new business models enter the marketplace. In order to continue growing, our business model must remain attractive to consumers so that we can compete successfully with these newer models as they expand into our marketplaces. In addition, to remain economically viable, we will need to be able to compete effectively with these new entrants for the acquisition of agents and leads.
Changes in federal and state real estate laws and regulations, and rules of industry organizations such as the National Association of REALTORS®, could adversely affect our business.
     The real estate industry is heavily regulated in the United States, including regulation under the Fair Housing Act, the Real Estate Settlement Procedures Act, state and local licensing laws and regulations and federal and state advertising laws. In addition to existing laws and regulations, states and industry participants and regulatory organizations could enact legislation, regulatory or other policies in the future, which could restrict our activities or significantly increase our compliance costs. Moreover, the provision of real estate services over the Internet is a new and evolving business, and legislators, regulators and industry participants may advocate additional legislative or regulatory initiatives governing the conduct of our business. If existing laws or regulations are amended or new laws or regulations are adopted, we may need to comply with additional legal requirements and incur significant compliance costs, or we could be precluded from certain activities. Because we operate through our website, state and local governments other than where the subject property is located may attempt to regulate our activities, which could significantly increase our compliance costs and limit certain of our activities. In addition, industry organizations, such as NAR and other state and local organizations, can impose standards or other rules affecting the manner in which we conduct our business. As mentioned above, NAR has adopted rules that, if implemented, could result in a reduction in the number of home listings that could be viewed on our website. NAR has extended the deadline for the implementation of its rules pending the resolution of a lawsuit filed in federal court by the Antitrust Division of the U.S. Department of Justice challenging, among other things, NAR’s proposed ILD policy that dictates how brokers can display other brokers’ property listings on their websites. We presently do not know whether or when the NAR rules will be implemented in their current form or in a revised form, if at all. The implementation of the rules will not limit our access to listing information, but could limit the display of listing information to our clients through our website in the manner we currently utilize, as well as increase our costs of ensuring compliance with such rules. Any significant lobbying or related activities, either of governmental bodies or industry organizations, required to respond to current or new initiatives in connection with our business could substantially increase our operating costs and harm our business.
We derive a significant portion of our leads through third parties, and if any of our significant lead generation relationships are terminated, impaired or become more expensive, our ability to attract new clients and grow our business may be adversely affected.
     We generate leads for our ZipAgents through many sources, including leads from third parties with which we have only non-exclusive, short-term agreements that are generally terminable on little or no notice and with no penalties. Our largest third-party lead

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source, Homegain, Inc., which competes with us for online customer acquisition, generated approximately 29% and 21% of our leads during 2005 and 2004, respectively. In addition, during the third quarter of 2004 our exclusive co-branded relationship which we had in four markets with one third-party lead source, Yahoo! Inc., ended, effective July 31, 2004. Leads from this source accounted for approximately 8% of our leads and approximately 8% of our net revenues during 2004. Should our lead replacement strategy upon the loss of a large lead supplier not be successful, or any of our other lead generation relationships become materially more expensive such that we could not obtain substitute sources on acceptable terms, our ability to attract new clients and grow our business may be impaired. Our business may also be impaired to the extent that state laws or NAR or MLS regulations make it more difficult or expensive for lead generators to provide us with sufficient leads.
Our ability to expand our business may be limited by state laws governing cash rebates to home buyers.
     A significant component of our value proposition to our home buyer clients is a cash rebate provided to the buyer at closing. Currently, our clients who are home buyers represent a substantial majority of our business and revenues. Certain states, such as Alaska, Kansas, Louisiana, Mississippi, New Jersey, Oklahoma, Oregon and Tennessee, may presently prohibit sharing any commissions with, or providing rebates to, clients who are not licensed real estate agents. In addition, other states may limit or restrict our cash rebate program as currently structured, including Missouri and New York. In connection with our announced plans to enter the Greater Philadelphia area, including New Jersey, and should we decide to expand into any of these other states, we may have to adjust our pricing structure or refrain from offering rebates to buyers in these states. Moreover, we cannot predict whether alternative approaches will be cost effective or easily marketable to prospective clients. The failure to enter into these markets, or others that adopt similar restrictions, or to successfully attract clients in these markets, could harm our business.
We may be unable to integrate our technology with each MLS on a cost-effective basis, which may harm our operating results and adversely affect our ability to service clients.
     Each MLS is operated independently and is run on its own technology platform. As a result, we must constantly modify our technology to successfully interact with each independent MLS in order to maintain access to that MLS’s home listings information. In addition, when a new MLS is created, we must customize our technology to work with that new system. These activities require constant attention and significant resources. We may be unable to successfully interoperate with the MLSs without significantly increasing our engineering costs, which would increase our operating expenses without a related increase in net revenues and cause our operating results to suffer. We may also be unable to interoperate with the MLSs at all, which may adversely affect the demand for our services.
We may be subject to liability for the Internet content that we publish.
     As a publisher of online content, we face potential liability for negligence, copyright, patent or trademark infringement, or other claims based on the nature and content of the material that we publish or distribute. Such claims may include the posting of confidential data, erroneous listings or listing information and the erroneous removal of listings. These types of claims have been brought successfully against the providers of online services in the past and could be brought against us or others in our industry. In addition, we may face liability if a MLS member or participant utilizes an opt-out provision, as previously discussed, and we fail to comply with that requirement. These claims, whether or not successful, could harm our reputation, business and financial condition. Although we carry general liability insurance, our insurance may not cover claims of these types or may be inadequate to protect us from all liability that we may incur.
We monitor and evaluate the use of our website by our registered users, which could raise privacy concerns.
     Visitors to our website that register with us receive access to home listing and related information that we do not make available to unregistered users. As part of the registration process, our registered users consent to our use of information we gather from their use of our website, such as the geographic areas in which they search for homes, the price range of homes they view, their activities while on our website and other similar information. They also provide us with personal information such as telephone numbers and email addresses and our registered users consent to our internal use of personal information. Our website includes a copy of our privacy policy, which sets forth our practices with respect to sharing website use and personal information when necessary to administer products or services we or our subsidiaries may provide, when we have users’ permission, when required by law, or as otherwise described in our privacy policy. If we were to use this information outside the scope of our privacy policy or otherwise fail to observe any legal obligation keep this information confidential from third parties, including our former agents, we may be subject to legal claims or government action and our reputation and business could be harmed. Also, concern among consumers regarding our use of information gathered from visitors to our website could cause them not to register with us, which would reduce the number of leads

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we derive from our website. Because our website is our primary client acquisition tool, any resistance by consumers to register on our website would harm our business and results of operations, and could cause us to alter our business practices or incur significant expenses to educate consumers regarding the use we make of information.
We may need to change the manner in which we conduct our business if government regulation of the Internet increases.
     The adoption or modification of laws or regulations relating to the Internet could adversely affect the manner in which we currently conduct our business. In addition, the growth and development of the market for online commerce may lead to more stringent consumer protection laws that may impose additional burdens on us. Laws and regulations directly applicable to communications or commerce over the Internet are becoming more prevalent. For example, both the U.S. government and the State of California have enacted Internet laws regarding privacy and sharing of customer information with third parties. Laws applicable to the Internet remain largely unsettled, even in areas where there has been some legislative action. It may take years to determine whether and how existing laws such as those governing intellectual property, privacy, libel and taxation apply to the Internet.
     In addition, because each state in which we do business requires us to be a licensed real estate broker, and residents of states in which we do not do business could potentially access our website, changes in Internet regulation could lead to situations in which we are considered to “operate” or “do business” in such states. This could result in potential claims or regulatory action.
     If we are required to comply with new regulations or new interpretations of existing regulations, we may not be able to differentiate our services from traditional competitors and may not attract a sufficient number of clients for our business to be successful.
Our operating results are subject to seasonality and vary significantly among quarters during each calendar year, making meaningful comparisons of successive quarters difficult.
     The residential real estate market traditionally has experienced seasonality, with a peak in the spring and summer seasons and a decrease in activity during the fall and winter seasons. Revenues in each quarter are significantly affected by activity during the prior quarter, given the typical 30- to 45-day time lag between contract execution and closing. Historically, this seasonality has caused our revenues, operating income, net income and cash flow from operating activities to be lower in the first and fourth quarters and higher in the second and third quarters of each year.
     Factors affecting the timing of real estate transactions that can cause our quarterly results to fluctuate include:
    timing of widely observed holidays and vacation periods and availability home buyers and sellers, real estate agents and related service providers during these periods;
 
    a desire to relocate prior to the start of the school year;
 
    inclement weather which can influence consumers’ desire or ability to visit properties;
 
    timing of employment compensation changes, such as raises and bonuses;
 
    the time between entry into a purchase contract for real estate and closing of the transaction; and
 
    the levels of housing inventory available for sale.
     We expect our revenues to continue to be subject to these seasonal fluctuations, which, combined with our recent growth, make it difficult to compare successive quarters.
Our reputation and client and agent service offerings may be harmed by system failures and computer viruses.
     The performance and reliability of our technology infrastructure is critical to our reputation and ability to attract and retain clients and agents. Our network infrastructure is currently co-located at a single facility in Sunnyvale, California and we do not currently operate a back-up facility. As a result, any system failure or service outage at this primary facility would result in a loss of service for the duration of the failure or outage. Any system error or failure, or a sudden and significant increase in traffic, may significantly delay response times or even cause our system to fail resulting in the unavailability of our Internet platform. For example, in the

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summer of 2006 we experienced unscheduled outages in our website and ZAP system due to our rollout of new software, and we may continue to experience such outages in the third quarter of 2006. Also, in 2005 we experienced an unscheduled outage that lasted approximately 12 hours. During this period our clients and prospective clients were unable to access our website or receive notifications of new listings. While we have taken measures to prevent unscheduled outages, outages may occur in the future. In addition, our systems and operations are vulnerable to interruption or malfunction due to certain events beyond our control, including natural disasters, such as earthquakes, fire and flood, power loss, telecommunication failures, break-ins, sabotage, computer viruses, intentional acts of vandalism and similar events. Our network infrastructure is located in the San Francisco Bay area, which is susceptible to earthquakes and has, in the past, experienced power shortages and outages, any of which could result in system failures and service outages. We may not be able to expand our network infrastructure, either on our own or through use of third party hosting systems or service providers, on a timely basis sufficient to meet demand. Any interruption, delay or system failure could result in client and financial losses, litigation or other consumer claims and damage to our reputation.
Our business is geographically concentrated, which makes us more susceptible to business interruption and financial loss due to natural disasters, inclement weather, economic or market conditions or other regional events outside of our control.
     Presently, our business is conducted principally in a few states in the western United States, especially California, and along the eastern seaboard. For example, we derived approximately 40% of our net transaction revenues in the quarter ended September 30, 2006 in the State of California. In addition, our servers and other technology infrastructure are located principally in the State of California. Our geographic concentration makes us as a whole more vulnerable to the effects of regional disasters in these areas, such as earthquakes, harsh weather, economic or market conditions or other events outside of our control, such as shifts in populations away from markets that we serve. These events could cause us to sustain a business interruption or other financial loss that would be greater than if our business were more dispersed geographically.
Our intellectual property rights are valuable and our failure to protect those rights could adversely affect our business.
     Our intellectual property rights, including existing and future patents, trademarks, trade secrets and copyrights, are and will continue to be valuable and important assets of our business. We believe that our proprietary ZAP technology and ZipNotify, as well as our ability to interoperate with multiple MLSs and our other technologies and business practices, are competitive advantages and that any duplication by competitors would harm our business. We have taken measures to protect our intellectual property, but these measures may not be sufficient or effective. For example, we seek to avoid disclosure of our intellectual property by requiring employees and consultants with access to our proprietary information to execute confidentiality agreements. We also seek to maintain certain intellectual property as trade secrets. Intellectual property laws and contractual restrictions may not prevent misappropriation of our intellectual property or deter others from developing similar technologies. In addition, others may develop technologies that are similar or superior to our technology, including our patented technology. Any significant impairment of our intellectual property rights could harm our business.
We may in the future be subject to intellectual property rights disputes, which could divert management attention, be costly to defend and require us to limit our service offerings.
     Our business depends on the protection and utilization of our intellectual property. Other companies may develop or acquire intellectual property rights that could prevent, limit or interfere with our ability to provide our products and services. One or more of these companies, which could include our competitors, could make claims alleging infringement of their intellectual property rights. Any intellectual property claims, with or without merit, could be time-consuming and expensive to litigate or settle and could significantly divert management resources and attention.
     Our technologies may not be able to withstand any third-party claims or rights against their use. If we were unable to defend successfully against such claims, we may have to:
    pay damages;
 
    stop using the technology found to be in violation of a third party’s rights;
 
    seek a license for the infringing technology; or
 
    develop alternative non-infringing technology.

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     If we have to obtain a license for the infringing technology, it may not be available on reasonable terms, if at all. Developing alternative non-infringing technology could require significant effort and expense. If we cannot license or develop alternative technology for the infringing aspects of our business on attractive terms, we may be forced to limit our product and service offerings. Any of these results could reduce our ability to compete effectively, and harm our business and results of operations.
If we fail to attract and retain our key personnel, our ability to meet our business goals will be impaired and our financial condition and results of operations will suffer.
     The loss of the services of one or more of our key personnel could seriously harm our business. For example, Eric A. Danziger, our former Chief Executive Officer, departed from the Company on August 1, 2006. Mr Danziger was succeeded by Mr. Richard F. Sommer, who assumed the position of Chief Executive Officer on September 6, 2006. Our success depends on the contributions of Mr. Sommer as well as the continued contributions of Gary M. Beasley, our President and Chief Financial Officer, and other senior level sales, operations, marketing, technology and financial officers. Our business plan was developed in large part by our senior level officers and its implementation requires their skills and knowledge. With the exception of Mr. Sommer and Mr. Beasley, none of our officers or key employees has an employment agreement, and their employment is at will. We do not have “key person” life insurance policies covering any of our executives.
We intend to evaluate acquisitions or investments in complementary technologies and businesses and we may not realize the anticipated benefits from, and may have to pay substantial costs related to, any acquisitions or investments that we undertake.
     As part of our business strategy, we plan to evaluate acquisitions of, or investments in, complementary technologies and businesses. We may be unable to identify suitable acquisition candidates in the future or be able to make these acquisitions on a commercially reasonable basis, or at all. If we complete an acquisition or investment, we may not realize the benefits we expect to derive from the transaction. Any future acquisitions and investments would have several risks, including:
    our inability to successfully integrate acquired technologies or operations;
 
    diversion of management’s attention;
 
    problems maintaining uniform standards, procedures, controls and policies;
 
    potentially dilutive issuances of equity securities or the incurrence of debt or contingent liabilities;
 
    expenses related to amortization of intangible assets;
 
    risks associated with operating a business or in a market in which we have little or no prior experience;
 
    potential write offs of acquired assets;
 
    loss of key employees of acquired businesses; and
 
    our inability to recover the costs of acquisitions or investments.
Accounting for employee stock options using the fair value method could significantly reduce our net income in future periods.
     In December 2004, the FASB issued its final standard on accounting for share-based payments, SFAS 123(R) (revised 2004), that requires companies to expense the value of employee stock options and similar awards. In April 2005, the Securities and Exchange Commission amended the compliance dates and, accordingly, we were required to record an expense for our stock-based compensation plans using the fair value method beginning on January 1, 2006. This expense will exceed the expense we previously recorded for our stock-based compensation plans and correspondingly reduce our net income in future periods.
The value of our services could be diminished if anti-spam software filters out an increasing portion of the emails we send.
     Our ZAP system includes a feature that sends out personalized email messages to our registered users on behalf of our agents. Given the volume of these messages, anti-spam software used by Internet service providers and personal computer users sometimes

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treats these messages incorrectly as unsolicited email, or “spam,” and filters them out. If this problem becomes more pervasive, the value of this aspect of our marketing and communication approach could be diminished, which could harm our business.
OTHER RISKS RELATED TO OUR STOCK PRICE
Our stock price may be volatile.
     The trading price of our common stock may fluctuate widely, depending upon many factors, some of which are beyond our control. These factors include, among others, the risks identified above and the following:
    variations in our quarterly results of operations;
 
    announcements by us or our competitors or lead source providers;
 
    the relatively low level of public float and average daily trading volumes of our common stock;
 
    changes in estimates of our performance or recommendations, or termination of coverage by securities analysts;
 
    inability to meet quarterly or yearly estimates or targets of our performance;
 
    the hiring or departure of key personnel (such as the recent departure of our former Chief Executive Officer, Eric A. Danziger), including agents or groups of agents or key executives;
 
    changes in our reputation;
 
    acquisitions or strategic alliances involving us or our competitors;
 
    changes in the legal and regulatory environment affecting our business; and
 
    market conditions in our industry and the economy as a whole.
     In addition, the stock market in general, and the market for technology companies in particular, have experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of those companies. These broad market and industry factors may seriously harm the market price of our common stock, regardless of our actual operating performance. Also, in the past, following periods of volatility in the overall market and the market price of a company’s securities, securities class action litigation has often been instituted against these companies. This litigation, if instituted against us, could result in substantial costs and a diversion of our management’s attention and resources and could harm the price of our common stock. Although we carry general liability and errors and omissions insurance, our insurance may not cover claims of these types or may be inadequate to protect us from all liability that we may incur.
Our share price could decline due to the large number of outstanding shares of our common stock eligible for future sale.
     The market price of our common stock could decline as a result of sales of substantial amounts of our common stock in the public market, or from the perception that these sales could occur. These sales could also make it more difficult for us to sell our equity or equity-related securities in the future at a time and price that we deem appropriate.
     As of September 30, 2006, we had 20,488,293 shares of common stock outstanding. All of these shares are eligible for sale, subject in some cases to the volume and other restrictions of Rule 144 and Rule 701 under the Securities Act of 1933.
     In addition, we have registered approximately 5.2 million shares of common stock that have been issued or reserved for future issuance under our stock incentive plans. Of those shares, options for 2,503,103 shares were vested as of September 30, 2006 and, if those options are exercised, those shares are eligible for sale. We have also registered 1.25 million shares subject to an option granted to our Chief Executive Officer, Richard F. Sommer, upon his commencement of employment in September 2006, which vests as to 25% on his first anniversary of employment with the remainder to vest ratably over the following three years. Also as of September 30, 2006, we had outstanding warrants for 4,603,088 shares that were fully vested and, if those warrants are exercised, those shares will be

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eligible for sale, subject to any Rule 144 waiting periods, volume, and other restrictions. Nearly all of those warrants (representing 4,599,804 shares) are exercisable at $3.93 per share and expire on the following dates: February 11, 2007 (1,080,972 shares), April 15, 2007 (986,320 shares), October 28, 2007 (582,060 shares), December 17, 2007 (1,354,723 shares), February 18, 2008 (274,365 shares), and June 27, 2008 (321,364 shares). Any sales of those shares prior to expiration of the warrants could have a dilutive effect on our stock price.
     Also, as noted above, our former Chief Executive Officer, Eric A. Danziger, resigned from the Company effective August 1, 2006. In connection with his departure, Mr. Danziger was granted the right to exercise his vested options (representing 1,378,962 shares) until December 31, 2006, of which at least 622,261 shares were exercised through October 31, 2006. Any sale by Mr. Danziger of those shares or of the other shares held by him or his affiliates (136,856 shares) or acquired by him upon the exercise of existing warrants (66,975 shares) could cause a decline in our stock price.
Our principal stockholders, executive officers and directors own a significant percentage of our stock, and as a result, the trading price for our shares may be depressed and these stockholders can take actions that may be adverse to your interests.
     Our executive officers and directors and entities affiliated with them, in the aggregate, beneficially own over half of our common stock. This significant concentration of share ownership may adversely affect the trading price for our common stock because investors often perceive disadvantages in owning stock in companies with controlling stockholders. These stockholders, acting together, will have the ability to exert control over all matters requiring approval by our stockholders, including the election and removal of directors and any proposed merger, consolidation or sale of all or substantially all of our assets. In addition, these stockholders who are executive officers or directors, or who have representatives on our Board of Directors, could dictate the management of our business and affairs. This concentration of ownership could have the effect of delaying, deferring or preventing a change in control, or impeding a merger or consolidation, takeover or other business combination that could be favorable to our other stockholders.
Our charter documents and Delaware law could prevent a takeover that stockholders consider favorable and could also reduce the market price of our stock.
     Our amended and restated certificate of incorporation and our bylaws contain provisions that could delay or prevent a change in control of our company. These provisions could also make it more difficult for stockholders to elect directors and take other corporate actions. These provisions include:
    providing for a classified board of directors with staggered, three-year terms;
 
    not providing for cumulative voting in the election of directors;
 
    authorizing the board to issue, without stockholder approval, preferred stock with rights senior to those of common stock;
 
    prohibiting stockholder action by written consent;
 
    limiting the persons who may call special meetings of stockholders; and
 
    requiring advance notification of stockholder nominations and proposals.
     In addition, the provisions of Section 203 of Delaware General Corporate Law govern us. These provisions may prohibit large stockholders, in particular those owning 15% or more of our outstanding voting stock, from merging or combining with us for a certain period of time.
     These and other provisions in our amended and restated certificate of incorporation, our bylaws and under Delaware law could discourage potential takeover attempts, reduce the price that investors might be willing to pay for shares of our common stock in the future and result in the market price being lower than it would be without these provisions.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds:
     On November 9, 2004, the Securities and Exchange Commission declared effective our Registration Statement on Form S-1 (File No. 333-115657) for our initial public offering. We commenced our offering immediately thereafter. We completed our sale of

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4,550,000 shares of common stock on November 15, 2004 at a price of $13.00 per share, and on November 18, 2004 we sold the remainder of our registered shares of common stock (682,500 shares) at the same price per share pursuant to the underwriters’ exercise of the over-allotment option. UBS Securities LLC, Deutsche Bank Securities Inc., Thomas Weisel Partners LLC and Pacific Growth Equities, LLC acted as the underwriters for the offering.
     The aggregate purchase price of the offering was $68,022,500. The net offering proceeds received by us after deducting total estimated expenses were $61,402,757. We incurred total estimated expenses in connection with the offering of $6,619,743, which consisted of $1,795,943 in legal, accounting and printing fees, $4,761,575 in underwriters’ discounts, fees and commissions, and $62,225 in miscellaneous expenses. No payments for such expenses were made directly or indirectly to (i) any of our directors, officers or their associates, (ii) any person owning 10% or more of any class of our equity securities or (iii) any of our affiliates.
     We have not used any of the net offering proceeds from the offering for operational purposes. We currently estimate that we will use the net proceeds as described in the prospectus for the offering: for general corporate purposes, including working capital. We have not assigned specific portions of the net proceeds for any particular uses, and we will retain broad discretion in the allocation of the net proceeds. Although we evaluate potential acquisitions of complementary businesses, technologies or other assets in the ordinary course of business, we have no specific understandings, commitments or agreements with respect to any acquisition at this time.
     Pending such uses, we have invested all of the net proceeds from the offering in short-term, investment-grade securities. We cannot predict whether the net proceeds invested will yield a favorable return.
Item 6. Exhibits:
     The exhibits listed in the Exhibit Index are filed as a part of this report.

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SIGNATURE
     Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
             
    ZIPREALTY, INC.    
 
           
 
  By:   /s/ Gary M. Beasley
 
Gary M. Beasley
   
 
      President and Chief Financial Officer    
Date: November 9, 2006

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Exhibit Index
     
Exhibit    
number   Description
3.1(a)(1)
  Amended and Restated Certificate of Incorporation
 
   
3.2(a)(1)
  Bylaws
 
   
4.1(1)
  Form of Common Stock Certificate
 
   
10.13(a)(2)*
  ZipRealty, Inc. Amended and Restated Management Incentive Plan — Fiscal Year 2006
 
   
10.16(3)*
  Offer Letter to Richard F. Sommer dated August 24, 2006
 
   
10.17(4)*
  Form of Stock Option Award Agreement between Company and Richard F. Sommer to be dated September 6, 2006
 
   
31.1
  Certification of Chief Executive Officer, as required by Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934
 
   
31.2
  Certification of Chief Financial Officer, as required by Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934
 
   
32.1
  Certification of Chief Executive Officer, as required by Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. 1350)
 
   
32.2
  Certification of Chief Financial Officer, as required by Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. 1350)
 
(1)   Incorporated by reference to the exhibit of the same number to the Registrant’s Registration Statement on Form S-1(File No. 333-115657) filed with the Securities and Exchange Commission on May 20, 2004, as amended.
 
(2)   Incorporated by reference to the exhibit of the same number to the Registrant’s Current Report on Form 8-K (File No. 000-51002) filed with the Securities and Exchange Commission on October 27, 2006.
 
(3)   Incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K (File No. 000-51002) filed with the Securities and Exchange Commission on August 30, 2006.
 
(4)   Incorporated by reference to Exhibit 10.2 to the Registrant’s Current Report on Form 8-K (File No. 000-51002) filed with the Securities and Exchange Commission on August 30, 2006.
 
*   Identifies a management contract or compensatory plan or agreement required to be filed as an exhibit of this report.

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